Investments, tenth edition

2

 Options  Markets: 

Introduction 

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T VI 

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  C H A P T E R  

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  Options Markets: Introduction 

679

  A    call  option    gives its holder the right to purchase an asset for a specified price, called 

the    exercise    ,   or     strike,  price    ,  on or before some specified expiration date. For example, 

a February call option on IBM stock with exercise price $195 entitles its owner to 

purchase IBM stock for a price of $195 at any time up to and including the expiration 

date in February. The holder of the call is not required to exercise the option. She will 

choose to exercise only if the market value of the underlying asset exceeds the exercise 

price. In that case, the option holder may “call away” the asset for the exercise price. 

Otherwise, the option may be left unexercised. If it is not exercised before the expira-

tion date of the contract, a call option simply expires and becomes valueless. Therefore, 

if the stock price is greater than the exercise price on the expiration date, the value of 

the call option equals the difference between the stock price and the exercise price; but 

if the stock price is less than the exercise price at expiration, the call will be worthless. 

The  net profit  on the call is the value of the option minus the price originally paid to 

purchase it. 

 The purchase price of the option is called the    premium    .  It represents the compensation 

the purchaser of the call must pay for the right to exercise the option only when exercise 

is desirable. 

 Sellers of call options, who are said to  write  calls, receive premium income now as pay-

ment against the possibility they will be required at some later date to deliver the asset in 

return for an exercise price less than the market value of the asset. If the option is left to 

expire worthless, the writer of the call clears a profit equal to the premium income derived 

from the initial sale of the option. But if the call is exercised, the profit to the option writer 

is the premium income  minus  the difference between the value of the stock that must be 

delivered and the exercise price that is paid for those shares. If that difference is larger than 

the initial premium, the writer will incur a loss. 

 

     20.1 

The Option Contract 

 Consider the February 2013 expiration call option on a share of IBM with an exercise 

price of $195 selling on January 18, 2013, for $3.65. Exchange-traded options expire on 

the third Friday of the expiration month, which for this option was February 15. Until the 

expiration date, the call holder may buy shares of IBM for $195. On January 18, IBM sells 

for $194.47. Because the stock price is only $194.47, it clearly would not make sense at 

the moment to exercise the option to buy at $195. Indeed, if IBM remains below $195 

by the expiration date, the call will be left to expire worthless. On the other hand, if IBM 

is selling above $195 at expiration, the call holder will find it optimal to exercise. For 

example, if IBM sells for $197 on February 15, the option will be exercised, as it will give 

its holder the right to pay $195 for a stock worth $197. The value of each option on the 

expiration date would then be   

Value at expiration 5 Stock price 2 Exercise price 5 $197 2 $195 5 $2  

 Despite the $2 payoff at expiration, the call holder still realizes a loss of $1.65 on the 

investment because the initial purchase price was $3.65:   

Profit 5 Final value 2 Original investment 5 $2.00 2 $3.65 5 2$1.65