Chapter 16
Introduction to Options
Money is made by discounting the obvious and betting on the unexpected.
I introduce options as hedging instruments in the next chapter. It is instructive, therefore, to develop some basics on option valuation so that we can better understand how to formulate portfolio strategies using this very flexible set of securities. This chapter is not intended to substitute for a more comprehensive treatment of this important class of derivatives; for that, I would suggest a book such as John Hull's Options, Futures, and Other Derivatives or David Luenberger's Investment Science. I borrow liberally from both in the discussion that follows. Like futures, forwards, and swaps, options are derivative securities whose values are tied to the value of some underlying security. For that reason, I include a section on asset price dynamics—models of derivative securities are only as good as the models of the underlying price dynamic.
In general, options are contracts that give the holder the right but not necessarily the obligation to sell or purchase a security over some interval into the future for a price agreed upon today. The price is referred to as the strike price (K) and if the option can be exercised at any time over its life, then it is an American option. If, on the other hand, the option can be exercised at a single specific date, it is a European option. We will study European options.
There are two general types of options, calls and puts. A call (put) option gives the holder the right to buy (sell) a security in the future at a known strike price. In the case of a call option, if the spot (S), or market, price of the security in question is greater than the strike price at the exercise date, then the option has value and will be exercised. In general, when the spot price exceeds the strike price, the call option is said to be in the money. Otherwise, the option is either at the money (spot equals strike) or out of the money (spot is less than the strike price). Out of the money options will not be exercised. Puts, on the other hand, have value when the spot price falls below the strike price. An example, which we develop in the next chapter, involves portfolio insurance in which the portfolio manager buys a put option to hedge the risk of his portfolio losing value. The put gives him the option of selling his portfolio at some agreed-upon price; therefore, if the market price of the portfolio falls below the strike price, this put has value. We will learn how to value these options.