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Focus on Options: Fundamentals

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As we have seen in earlier sections, if you buy an option contract you are buying the option, or "right" to trade a particular underlying instrument at a stated price.

An option that gives you the right to eventually make a purchase at a predetermined price is called a "call" option. If you buy that right it is called a long call; if you sell that right it is called a short call. An option that gives you the right to eventually make a sale at a predetermined price is called a "put" option. If you buy that right it is called a long put; if you sell that right it is called a short put.

In this section we are going to both elaborate on these basic characteristics and also provide a number of examples of how options contracts can be used. In the course of doing this we are going to employ the use of what are called ‘profit/loss’ or ‘payoff’ diagrams. So we will begin with what these are and how they work.

A profit/loss graph shows, as the name suggests, the potential profit and loss inherent in a particular option position. We will start with call options.

Suppose a call option with an exercise/strike price equal to the price of the underlying (100) is bought today for $1.

At expiry, if the security’s price has fallen below the strike price, the option will be allowed to expire worthless and the position has lost $1. This is the maximum amount that you can lose because an option only involves the right to buy or sell, not the obligation. In other words, if it is not in your interest to exercise the option you don’t have to and so – if you are an option buyer – your maximum loss is the premium you have paid for the right.

If, on the other hand, the security’s price rises, the value of the option will increase by $1 for every $1 increase in the security’s price above the strike price (less the initial $1 cost of the option).

Note that if the price of the underlying increases by $1, the option purchaser breaks even - breakeven is reached when the value of the option at expiry is equal to the initial purchase price. For our call option, the breakeven price is 101. If the price of the security is greater than 101, the call buyer makes money.

Now look at the profit/loss for a short call.

Here profit is limited to the premium received for selling the right to buy at the exercise price - again $1.

For every $1 rise in the price of the underlying security above the exercise price the option falls in value by $1.

Here again, the breakeven point is 101.

     

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