This video gives an insight into the conditions under which options traders exercise long/short put and call options, and the favourable conditions for straddle traders.
Key learning objectives:
- Define short/long call and put options, and state when an options trader will exercise them
- What are asymmetric payoffs?
- What is a straddle trade?
What are call and put options?
- A call option - The option to buy, but which comes with a choice at the end, for the owner of the option, of whether or not to go through with the settlement of the forward trade. The buyer of the call option has the option to settle the long forward trade - they are long the call option.
- A put option - The option to sell
Using the figure below, when will the option be exercised?Let’s assume the put option costs $50 per ounce.
- Now we see that if the platinum price ends up above $1000 an ounce, they lose $50 per share. In this case the option is “out of the money”.
- The put is “in the money” when the price of the underlying platinum ends up below the $1000 per ounce level - the “strike” of the option. And if the price ends up even lower, below $950, then they make back the premium plus more.
Using the figure below, how do these options look from the sellers perspective?The seller takes in the premium and then becomes short the option - they take in the premium of $50 per ounce.
- If the platinum price ends up below $1000, then the option will be left to expire worthless by the buyer. The value of the position ends up at $50 - to the seller.
- However, if the platinum price ends up above $1000, then the buyer of the option will exercise the option. As this is a call option, when the buyer exercises, they will buy for the strike price of $1000 per ounce. This means that the seller of the option will be selling platinum at $1000 an ounce, even though the price is higher, and therefore is effectively losing money.