By Dino Zannoni
Options Tutorial: Put Call and Strike
What is an Option?
An Option is a contract whereby the buyer has the right but not the obligation, to buy (call) or sell (put) a certain amount of the underlying within (American option) or at (European option) a specified deadline (Expiry date), at a level of predetermined price (strike price).
In order to obtain this right, the buyer of the option has to pay the other party a price.
- Price: it is the price to pay to buy the option;
- Issuer: it is the institution that meets the obligations contained in the contract;
- Price range: also called the “strike price“, it is the price you can buy or sell the underlying financial asset;
- Underlying: it is the financial asset (interest rates, exchange rates, individual stocks, basket of shares, indices) to which the right to buy or sell refers;
- Multiple: it is the amount of the underlying that you have the right to buy or sell (i.e. a warrant with 1/1 multiple is said to “control” a unit of underlying);
- Style: American or European;
- Exercise: the exercise of the right may result in the physical delivery of the underlying (settlement by delivery), or the payment of an amount in euro equal to the difference, if positive, between the current value of the underlying asset and the strike price (cash settlement) ;
- Moneyness (for the call), “in the money” when the strike price is lower than the price of the underlying; “at the money” when the strike price is equal to the price of the underlying; “out of the money” when the strike price is higher than the price of the underlying.
To give a concrete example of an action based option, the buyer of the European call option on the ENI action at 10 Euro means that, at the expiry date, the customer will have the right to buy the ENI stock at 10 Euro. Obviously everything will be reversed as the right to sell at a certain price (strike) at a certain date, in the case of a put option contract.
The Call and / or Put options can be purchased on regulated markets where the features are standardized, or can be purchased on the Over The Counter market and in this case the liquidity is guaranteed by a bank or a broker.
So an option can have any currency cross as an underlying and is commonly used to hedge the exchange rate risk.
An example may help to understand how it works.
A 100,000 purchase of an European Call Eur Put Usd option with a strike price 1.3050 expiry date 3 months from the signing of the contract, requires the payment of a price of 0.0150. In this case, the buyer will pay the price for the right to buy EurUsd at the change of 1.3050 (strike price) in case EurUsd at the expiry date is higher than the strike of 1.3050, while he will not exercise any right if it is lower than the strike price. In this case, the break-even point for the buyer will be represented by the sum of the strike price (1.3050) and the price (0.0150), or 1.3200.
What really makes the value of an option
In order to calculate the theoretical value of an option, there are several complex models that depend on the following variables:
- Market price of the underlying instrument
- Exercise price (strike price)
- Expiry Date
- Interest rates
The price of an option is composed by 2 parts:
- The intrinsic value, i.e. the difference (in case it is positive of course, otherwise the intrinsic value is set to zero) between the price of the underlying and the exercise price (strike price) in case of a CALL option and the exercise price and the price of the underlying in case of a PUT option;
- The time value, to be calculated indirectly as the difference between the option price and the intrinsic value. In fact, the time value depends on a number of variables such as the time to expiration, the volatility of the underlying, the current level of interest rates;
OPTION VALUE = TIME VALUE + INTRINSIC VALUE