Options 101

Vertical axis – payoff
Horizontal axis – share price

WHAT ON EARTH IS THAT?!
That ladies and gentlemen, is what we call a payoff diagram. Remember it well.
In case you’re wondering what Long, Short, Call and Put means….well…..(phew, this is gonna be a long day)

Here are some useful terminologies :
Long – to buy

Short – to sell

Call – a contract whereby the buyer has the option but not the obligation to purchase the underlying asset at the contracted price (exercise price) anytime before the expiry of the contract (American Option).

Put – a contract whereby the buyer has the option but not the obligation to sell the underlying asset at the contracted price anytime before the expiry of the contract.

Expiry – maturity of the contract

Exercise price – the contracted price that is agreed between the buyer and seller.

Underlying asset - It can be anything from, company shares, to commodities, and to even the weather!

American Options & European Options – most options are categorized into these 2 forms. Basically an American Option allows the option buyer to exercise his right anytime between the initiation of the contract to the expiry of the contract. On the other hand, European Options will only allow the option buyer to exercise his rights at the option contract expiry date.


So what exactly do I mean when I say, “I just did a transaction whereby I long an American call on 1000 Rolls Royce shares at an exercise price of 6 dollars expiring in August’07”?

Any takers?

Well, it means that I just bought the right to purchase 1000 Rolls Royce shares for the price of 6 dollars anytime from now till the expiry of the contract, which is in August 2007.

Here’s another Example:

“I just short an European call on 1000 Royal Bank of Scotland shares at an exercise price of 5 dollars expiring in September ‘07”

What does all this mumbo jumbo mean?
As a seller of a call option, I am now obligated to sell to the call option buyer, 1000 Royal Bank of Scotland shares at 5 dollars at the expiry date of the contract in September’07, IF he decides to exercise his rights (note – option is only exercisable on expiry because its an European option)

Now, I’m pretty sure all this is pretty confusing especially to those new to options. So I’ll leave it here for now and allow you lot to reflect on all these new terminologies.

In my next entry, I shall be explaining the payoff diagram.

And after that, we shall explore the trading strategy which I mentioned in my first entry.

(Coming up next – Options 102)