Options

Option Pricing Theory and Applications

Aswath Damodaran

Aswath Damodaran

184

What is an option?

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An option provides the holder with the right to buy or sell a specified quantity of an underlying asset at a fixed price (called a strike price or an exercise price) at or before the expiration date of the option. Since it is a right and not an obligation, the holder can choose not to exercise the right and allow the option to expire. There are two types of options - call options (right to buy) and put options (right to sell).

Aswath Damodaran

185

Call Options

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A call option gives the buyer of the option the right to buy the underlying asset at a fixed price (strike price or K) at any time prior to the expiration date of the option. The buyer pays a price for this right. At expiration,

• If the value of the underlying asset (S) > Strike Price(K)

– Buyer makes the difference: S - K

• If the value of the underlying asset (S) < Strike Price (K)

– Buyer does not exercise

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More generally,

• the value of a call increases as the value of the underlying asset increases • the value of a call decreases as the value of the underlying asset decreases

Aswath Damodaran

186

Payoff Diagram on a Call

Net Payoff on Call

Strike Price Price of underlying asset

Aswath Damodaran

187

Put Options

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A put option gives the buyer of the option the right to sell the underlying asset at a fixed price at any time prior to the expiration date of the option. The buyer pays a price for this right. At expiration,

• If the value of the underlying asset (S) < Strike Price(K)

– Buyer makes the difference: K-S

• If the value of the underlying asset (S) > Strike Price (K)

– Buyer does not exercise

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More generally,

• the value of a put decreases as the value of the underlying asset increases • the value of a put increases as the value of the underlying asset decreases

Aswath Damodaran

188

Payoff...