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Call and Put Options

There was a time when opening the mail was something that people looked forward to. That is no longer the case. So imagine your sur prise if one morning you received a letter from your stockbroker enclosing a cer tificate, given in recognition of past business you have given them, that gave you the “oppor tunity” to buy a 15-year government bond at a price of $11 500. The offer is for one month only and can be taken up by presenting the cer tificate plus $11 500 in cash to the broker at any time till then. A quick look at a financial newspaper, however, shows that its current market price is just $11 015. At first glance this does not appear to be a very attractive offer. If you wanted to hold the bond then you could simply buy it in the market today at $11 015.
A little thought, however, shows that the cer tificate is wor th holding onto. If the bond price rises above $11 500 at any time during the offer period then you can exercise this “option” and immediately sell the bond in the market. The difference between the then market price and the exercise price will be straight profit.
There are two types of options, call options and put options:
Call option. The above free offer is an example of a call option. In formal terms a call option gives the holder the right, but not the obligation, to buy a specified asset at a specific price (the exercise or strike price) until a par ticular date (the expir y date). The par ty giving the option is called the option writer.
Put option. The second type of option is a put option. This gives the holder the right, but not the obligation, to sell a specified asset at a specific price (the exercise or strike price) until a par ticular date (the expir y date). If the price of the bond is below the bond price then the holder can simply buy the bond in the market and exercise the option to immediately sell the bond at the exercise price. The holder’s profit then is the difference between the bond’s market price and the strike price.
The returns for this option for the holders and writers of a call option and a put option, plotted against bond price, are shown in the following char ts. It is wor th noting that trading options is a zero sum game, what one par ty gains another loses.
Call option. The call option returns have the following characteristics:
If the price remains below the strike price the holder will not exercise the option and it will simply expire.
The returns to the holder and the writer are mirror images of one another.
The returns are asymmetric in form with regard to bond price.
If the price rises above the strike price profits to the holder and losses to the writer have no limit.
Put option. The put option returns have the following characteristics:
If the price remains above the strike price the holder will not exercise the option and it will simply expire.
The returns to the holder and the writer are mirror images of one another.
The returns are asymmetric in form with regard to bond price.