Options Quick Notes
• Definition: An option is a financial derivative that gives the holder the
right, but not the obligation, to buy or sell an underlying asset at a
predetermined price (the strike price) before or at expiration.
Types of Options
1. Call Options:
o Definition: A call option gives the holder the right to buy an
underlying asset.
o Use: Typically used when the investor expects the price of the
underlying asset to rise.
o Components:
▪ Strike Price: Price at which the asset can be bought.
▪ Expiration Date: Date by which the option must be
exercised.
2. Put Options:
o Definition: A put option gives the holder the right to sell an
underlying asset.
o Use: Generally used when the investor expects the price of the
underlying asset to fall.
o Components:
▪ Strike Price: Price at which the asset can be sold.
▪ Expiration Date: Date by which the option must be
exercised.
Key Concepts
• Premium: The price paid for purchasing an option. It is determined by
factors such as the underlying asset's price, strike price, time until
expiration, volatility, and interest rates.
• In the Money (ITM):
o Call Option: When the underlying asset's price is above the strike
price.
o Put Option: When the underlying asset's price is below the strike
price.
• At the Money (ATM): When the underlying asset's price is equal to the
strike price.
• Out of the Money (OTM):
o Call Option: When the underlying asset's price is below the strike
price.
o Put Option: When the underlying asset's price is above the strike
price.
Pricing Models
• Black-Scholes Model: A mathematical model for pricing European-style
options, taking into account the stock price, strike price, time to
expiration, risk-free interest rate, and volatility.
• Binomial Model: A more flexible model that can be used for American
options, which can be exercised at any time before expiration.
Strategies
1. Covered Call: Involves holding a long position in an asset and selling call
options on the same asset to generate income.
2. Protective Put: Buying a put option while holding the underlying asset to
protect against potential losses.
3. Straddle: Buying both a call and a put option at the same strike price and
expiration date, benefiting from large price movements in either
direction.
4. Spread: Involves buying and selling options of the same class (calls or
puts) on the same underlying asset but with different strike prices or
expiration dates.
Risks and Considerations
• Leverage: Options can offer significant leverage, allowing for larger
potential gains but also larger potential losses.
• Expiration Risk: Options have a finite life and can expire worthless if the
underlying asset does not move in the anticipated direction.
• Market Volatility: High volatility can increase the premium of options,
making them more expensive.
• Liquidity Risk: Some options may have low trading volume, leading to
wider bid-ask spreads.
