Options (Part 1)
Options are the first thing many people think of when they hear the word “derivatives.” Compared with what we have done so far, they are a much more technical product and, done properly, even a general overview of their structure, pricing, and risk management will involve a certain amount of mathematics. While some may prefer a purely qualitative treatment, it is neither worthwhile nor admirable to attempt a presentation of options that is devoid of any mathematical content. Mathematics is an inescapable part of many areas of finance and the analysis of options is one of them.
In order for the concepts presented to have the highest probability of being both understood and retained by the greatest number of readers, I have kept the mathematics to a level that can reasonably be expected of a recent university graduate or a professional in the financial services industry. Readers whose mathematical skills are a bit rusty should refer to the Appendix for a brief refresher. I would actually recommend a quick read through of this appendix for most readers who do not have a natural predisposition for (or interest in) mathematics; the presentation focuses on understanding, rather than computation, and the material covered is generally elementary—basic ideas from algebra, calculus, probability, and statistics that should be understood by any educated adult.
Throughout this chapter and the next, wherever possible, concepts are illustrated via ...