An option is a contract which gives its holder the right to buy (or sell) an asset at some predetermined price within a specified period of time. Pure options are instruments that
(a) Are created by outsiders rather than the firm (usually investment bankers)
(b) Are bought and sold primarily by investors
(c) Are of greater importance to investors than to financial managers
10.1 TYPES OF OPTIONS
(a) Call Option
A call option gives the holder the right to buy an asset (or security) at a specified price (exercise price or striking price) within a specified period (exercise date). The seller is called a writer.
An investor who writes a call option against securities held in his portfolio is said to be selling covered options. Options sold without the stock to back them up are called naked options.
When the exercise price exceeds the current stock price, the option is said to be out-of-money. When the exercise price is less than the current price of the underlying stock, the option is said to be in-the-money.
(b) Put Options
An investor can also buy an option which gives him/her the right to sell a security at a specified price within some future period. This is called a put option.
10.2 FACTORS THAT AFFECT THE VALUE OF A CALL OPTION
(a) The market price of the underlying shares.
The higher the share price, the higher will be the call options price.
(b) The higher the striking price, the lower will be the call option's price.
(c) The longer the option period, the higher will be the option price because the longer the time before expiry, the greater the chance that the stock price will increase substantially above the exercise price.
Theoretical value = Current market — Exercise Price
of option (Expiry Value) price per share
THE BLACK AND SCHOLES OPTION PRICING MODEL (OPM)
This model was developed in 1973 and, it has the following assumptions:
1. The stock underlying the call option provides no dividends or other distribution during the life of the option.
2. There are no transaction costs in buying or selling either the stock or the option.
3. The short—term, risk free rate is a known constant during the life of the option.
4. Any purchaser of a security may borrow any fraction of the purchase price at short—term risk free interest rate.
5. Short selling is permitted without penalty and the short seller will receive immediately the full cash proceeds of today's price for a security sold short.
6. The call option can be exercised only on its expiration date (European option).