Question

1. Generalize the formulas for determining the value of the following four option types: buying a call, buying a put, writing a call, writing a put.

Answer 1

Call option

A call will be exercised by the buyer only if the stock price in the market is higher than the exercise price of the call option. Thereby the buyer will be able to make a profit by buying the share at a lower price.

• For buying a call , the value of option = Max[ Stock price- Exercise price, 0]

A writer of the call makes a profit only if call is not exercised by the buyer of call. Payoff of writer is the difference between the Exercise price and Stock Price or Zero, whichever is minimum.

• For writing a call, the value of option= Min [Exercise price-Stock price,0]

Put option

A put will be exercised by the holder of the put if the stock price in the market is lower than the exercise price of the put. Hence buyer of a put will make profit by selling the put at a rate higher than rate at which the stock is trading in the market.

• For buying a put, the value of option= Max [Exercise price-Stock price, 0]

A writer of put makes a profit when the stock is trading at a price higher in the market than the exercise price. In such a case the buyer of put will not exercise the option.

• For writing a put, the value of option= Min [Stock price-Exercise price,0]