Foundations of Finance

Lecture 9 – Notes 2 of 2
Arbitrage: Options Contracts (Part A)
Lecture Overview
In the rest of today’s lecture, we will discuss another
type of derivative called an option contract. Today we
will focus on discussing:
– What option contracts are
– The characteristics of option contracts
– How option contracts are similar to and differ from
forward and futures contracts
– Examine when options will be exercised

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 Topic 9.2.1
Introduction to
Options Contracts

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What is an Option Contract?
A contract that gives the buyer of the option the
right, but not the obligation to buy (call option) or
sell (put option) the underlying asset at a
predetermined price (exercise price) to the seller
of the option:
– In other words, the buyer (holder, or person in the long
position) has a right to exercise (or to enforce the
contract)
– But the seller (writer, or person in the short position)
must comply with the buyer’s decision

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Terms of an Options Contract
An option contract specifies:
– Whether the option gives the buyer a right to buy the
underlying asset (a call option) at the exercise price or
a right to sell the underlying asset (a put option) at the
exercise price
– The exercise or strike price, X (i.e. the fixed price at
which the asset may be bought / sold by the option
holder in the future)
– The maturity or expiration date, which is the
terminating date of the option. The time to expiry is
denoted T

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Terms of an Options Contract
An option contract specifies (cont.):
– The specific asset underlying the option contract
– The amount of the asset that may be bought or sold
under the option contract
– Whether the option is American (i.e. it can be
exercised at any time before or on expiry) or
European (i.e. it can only be exercised at one point in
time, expiry) in nature

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Call Options
A call option has the following features:
– It gives the holder (the person in the long position) the
right but not the obligation to buy the asset underlying the
contract at a fixed price X in the future
– The writer of the option (the person in the short position)
is obliged to sell the asset if the holder exercises their
right to buy it under the option contract
– If the option can only be exercised by the holder at expiry,
it is known as a European call option. If the option can be
exercised by the holder at any time before expiry or at
expiry, it is known as an American call option

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Put Options
A put option has the following features:
– It gives the holder (the person in the long position) the
right but not the obligation to sell the asset underlying
the contract at a fixed price X in the future
– The writer of the option (the person in the short position)
is obliged to buy the asset if the holder exercises their
right to sell it under the option contract
– If the option can only be exercised by the holder at
expiry, it is known as a European put option. If the
option can be exercised by the holder at any time before
expiry or at expiry, it is known as an American put
option
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Identifying the Positions: Start Long

Position Option Type

Long Call

Buy the option to buy the underlying asset

Long Put

Buy the option to sell the underlying asset

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 Then Move to Short
The long and short positions are on opposing
sides of the trade
Call:
– Long call: buy the option to buy the underlying asset
– Short call: sell the option, and therefore must sell the
underlying asset if the long call exercises the contract
Put:
– Long put: buy the option to sell the underlying asset
– Short put: sell the option, and therefore must buy the
underlying asset if the long put exercises the contract
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When Will an Option be Exercised?
As the option holder (the person in the long
position) decides whether or not the option will be
exercised, they will obviously only decide to
exercise when it benefits them (when the option is
in the money):
– Call Option: When the price the holder can buy for in
the spot market, S, is greater than the price they
would pay for the asset under the option, X
– Put Option: When the price the holder can sell for in
the spot market, S, is less than the price they would
sell for the asset under the option, X

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Payoff of an Option for the Holder
Given this, the gain (payoff) the holder makes from
the option can be expressed as follows:
– Call Option: (ST-X) if ST>X, 0 otherwise (as the holder
won’t exercise the option if ST<X because it is out of the
money). In other words, the payoff is max(ST-X,0)
• Call options are in the money when ST > X, at the money when
ST = X, and out of the money when ST < X
– Put Option: (X-ST) if X>ST, 0 otherwise (as the holder
won’t exercise the option if X<ST because it is out of the
money). In other words, the payoff is max(X-ST,0)
• Put options are in the money when X > ST, at the money when X
= ST, and out of the money when X < ST

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Payoff of an Option for the Writer
The payoff for the writer of the option or the person
in the short position is exactly the opposite of the
payoff for the holder, or:
– Call Option: -(ST-X), or (X- ST), if ST>X, 0 otherwise
(as the holder won’t exercise the option). In other
words, the payoff is –[max(ST -X, 0)], or min (X-ST,0)
– Put Option: -(X-ST), or (ST-X) if X> ST, 0 otherwise (as
the holder won’t exercise the option). In other words,
the payoff is –[max(X-ST, 0)], or min (ST-X,0)

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 Topic 9.2.2
Options:
Payoff Diagrams

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Payoff Diagrams for Options
We can graph the relationship between the spot
price at maturity (ST) and the payoff to both the
long (holder) and short (writer) positions in options
using what are called payoff diagrams
Consider the following payoff diagrams, noting that
examination of these diagrams confirms the payoff
for the holder is the exact opposite of the payoff for
the writer of the option:

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Payoff Diagram: Long Call Option
Note: a long call option
payoff diagram is similar
to the payoff/profit
diagram for a long
forward/futures contract,
but without the
downside (the downside
has been eliminated
due to the optionality of
this derivative for the
holder of the contract)

Reason: in both cases,

you are buying the
underlying asset

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Payoff Diagram: Short Call Option

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Payoff Diagram: Long Put Option
Note: a long put option
payoff diagram is similar
to the payoff/profit
diagram for a short
forward/futures contract,
but without the downside
(the downside has been
eliminated due to the
optionality of this
derivative for the holder
of the contract)

Reason: in both cases,

you are selling the
underlying asset

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Payoff Diagram: Short Put Option

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When Will an Option be Exercised?
Given the holder of the option will only exercise the
option if it benefits them (i.e. their minimum payoff
is 0) and the payoff for the writer is the exact
opposite of the holder’s payoff (i.e. their maximum
payoff is 0), why would anyone want to be the
writer of an option?
More on this next week…

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Next Week…
Next week, we will finish off the Options
topic. We will continue examining when
options will be exercised and look at how to
value options using the concept of no
arbitrage

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