5
Options processing
Option contracts have different characteristics to futures. The key
differences are that options are based on calls and puts. Options are
traded on- and off-exchange and are usually referred to as traded
options when based on a security or currency and as options on
futures or futures options when the underlying is a futures contract.
A call option gives the buyer the right, but not an obligation, to take
delivery of the underlying, whilst a put option confers the right but
not the obligation to make delivery of the underlying.
As a result of this characteristic the risk/reward profile is very dif-
ferent for the buyer and the seller. The buyer cannot lose more than
they pay for securing the right. This is shown in Figure 5.1.
In the Figure 5.1 the option is illustrated by the bold line. If the
buyer paid 10 for the right to buy a call option then the maximum
loss that can be made is 10 and we see the bold line takes a horizon-
tal line when that amount of loss of value is reached. However, the
underlying is shown as the dashed line and here the loss continues
as the underlying falls in value. On the upside the underlying imme-
diately makes a profit as the price rises but cost of securing the right
must first be recovered by the rise before a profit can occur. This is
shown in the Figure 5.1 by the bold line crossing the arrowed line
further along the rise, i.e. after it has increased in price by 10. For
the option buyer this is the breakeven point and any further increase
in the value of the underlying will be a profit. Conversely, for the
seller this is the point when a loss will start to occur.
The situation for the buyer of a put option is reversed as shown in
Figure 5.2.
The seller of the option, called the writer, has an obligation. They
receive the payment from the buyer to secure the right, often referred
to as the premium, but must wait to see if the buyer exercises their
right. If they do not, then the writer keeps the premium. If they do,