Lesson 4 of 7 · All lessons in this module
- Forward contracts and firm commitments
- Futures contracts and daily settlementVideo lesson
- Swaps as a series of forwardsVideo lesson
- Options and call payoffsVideo lesson
- Put payoffs and the four option positionsVideo lesson
- Credit default swapsVideo lesson
- Forward commitments versus contingent claimsVideo lesson
Lesson 4 of 7 · 13 min
Options and call payoffs
An option gives its buyer the right, but not the obligation, to buy (call) or sell (put) at a fixed price, so the buyer's payoff can never be negative and the buyer pays a premium for that.
In short
- Options are contingent claims: the buyer decides whether the trade happens. The seller must perform if the buyer exercises.
- The buyer pays the seller a premium up front. The agreed price is the exercise (strike) price, X. European options exercise only at maturity; American at any time.
- A call is in the money when ; its intrinsic value is . At or out of the money, the price is pure time value, which decays to zero at maturity.
- Long call: payoff , profit , breakeven . Loss capped at the premium; upside unlimited.
- Short call: profit at most the premium, losses unlimited. Once the premium is paid, only the buyer faces counterparty credit risk.
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