The Financial Engineer

What is it ?

• A European Call (Put) is the right to purchase (to sell) a specified quantity of an underlying asset, at an specific price, on and only on the expiration date.

How is it constructed ?

• Premium paid for the right to buy, or received for having written options.
• Position is margined through a clearing house, to reduce the chance of either party defaulting while owing a large sum.
• Valuation of option depends on 6 variables :  Spot price of underlying, Expiration time, Strike price, Interest rates, Dividends, Volatility

What is the payoff ?                                 

Long 

• Max profit: unlimited
• Max loss: premium

Short

• Max profit: premium
• Max loss: unlimited

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Long 

• Max profit: limited (S=0)
• Max loss: premium

Short

• Max profit: premium
• Max loss: limited (S=0)

When is it used ?

• Investors seeking leveraged exposure to an underlying.
• Most index options are in the European form.
• Call options enable investors to “call the bottom” of a downward trend while minimising potential losses.
• Investors can reposition their risk profiles.
• Long positions are sometimes taken with the expectation of higher volatility.
• Call overwriting strategies can increase the yield on a shareholding. All premium will be retained as a profit as long as the the shares do not rise above the strike of the calls by expiry.
• Plain vanilla options can be combined to create other strategies (e.g straddle)

What are the benefits ?

• Take adventages of price fluctuation in the underlying asset without risking  more than a premium (monetise volatility).
• Geared  exposure to an underlying price
• Insure against a fall in the price of the underlying.
• Generate yield ( for sellers)
• Defer the decision of buying the underlying asset during periods of price uncertainty.