(a) What is the payoff profile of a buyer and a writer of an option?

(b) What causes option’s premium to change over time?

Expert Solution

(a) Pay off profile of a buyer of an option; It may be call option and put option.

Call Option-Long call

In a call option the buyer gets right to buy underlying asset at the strike price which is alreadys specified in the option. Spot price of the underlying assets determines the amount of profit or loss the buyer gets on the option. At the time of expiration if the spot price is more than the strike price buyer will get profit. If the spot price high ,the profit will also be high. If the spot price of the underlying assets is less than the strike price buyer lets his option expire un-exercised. And he loss the premium he paid for buying the option.

Call option -Short call

It gives the buyer the right to buy the underlying asset at the strike price s already specified in the option. For selling a option, the writer/seller of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying asset ,What is is the buyer’s profit is the seller’s loss. If upon expiration, the spot price is more than the strike price, the buyer will exercise the option on the writer. When the spot price increases the writer of the option will suffer losses. If on the expiry date the spot price of the underlying is less than the strike price, the buyer lets his gives the payoff for the writer.

Put Option-Long Put

In this the buyer get the right to sell the underlying asset at the strike price already specified in the option. Just like call option the profit/loss that the buyer makes on the option depends on the spot price of the underlying. If on the expiry date, the spot price is below the strike price, buyer get a profit. Lower the spot price more is the profit he gets. If the spot price of the underlying higher than the strike price, buyer lets his option expire un-exercised. Buyers loss here is the premium he paid for buying the option.

A put option

On expiration, the spot price is below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying more than the strike price, the buyer lets his option unexercised and the writer get to keep the premium.

(b) Option premium is the price paid by buyer to selller of a option contract. The options premium changes frequently. Option premium is highly depend on the value of underlying asset,level of risk,and the time left in the contract. In case of IN THE MONEY there will be high premium. In the case of OUT OF THE MONEY there will be lower premium.

jeff jeffy answered 2 years ago

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