 |
 |
Lesson 1: With call options, if the stock price goes above the option's strike price, you can make a lot of money. If it doesn't, you lose your entire investment.
Let's say:
Your favorite stock currently is trading at $100.00. For whatever reason, you believe that, over the coming year, sooner or later, the trading price of the stock will shoot up by 20% or more.
You buy a call option on the stock.
The option has a strike price of $110.00.
The option expires in one year (252 trading days from now).
The option costs you $10.02.
What kind of payoff might you get from the option?
If your forecast is correct, what return might you earn on your $10.02 investment?
To find out, let's run a simulation.
(If you haven't already, to open the simulator, click the link at top right of this page. To jump quickly back and forth between the lesson and the simulator, hold down the Alt key on your keyboard and tap the Tab key.)
Type 1 in the Run Lesson Number box. Click Run Lesson Number.
In the simulation, the horizontal yellow line represents the option's strike price at $110.00. To get a payoff from the option, the stock price has to finish above the yellow line.
The distance from the yellow line to the green line represents what you paid for the option: $10.02. To make a profit on the option, the stock price has to finish above the green line.
For example, if, at the time of the option's expiration, the stock price is $178.02, then
| End-of-period price | $178.02 |
| - Strike price | $110.00 |
| = Payoff | $68.02 |
Your profit is equal to the payoff minus the cost of the option:
| Payoff | $68.02 |
| - Option Price | $10.02 |
| = Profit | $58.00 |
Option modeling uses geometric rates of return (which are also known as continuously compounded rates of return). On the investment in our example, we have a continuously compounded rate of return of 191.52% which is equal to a holding period return of 578.80%.
To simulate other payoffs you might get from this call option, click the button Simulate Price Change.
With geometric returns, if you lose all your money, you have a continuously compounded rate of return of negative infinity.
To continue to the next lesson, click arrow at top right of this page or...
Option Pricing: Black- Scholes Made Easy
or with author and developer Jerry Marlow
jerrymarlow@jerrymarlow.com
(917) 817-8659
www.jerrymarlow.com
|
|