CFM13200 - Understanding corporate finance: derivative contracts: options: how options work

How options work

Someone who holds an option is under no compulsion to exercise it. If he or she would lose money by exercising the option, they can simply let the option lapse. All they will have lost is the premium that they have paid.

Example 1

Filnog Ltd holds an option exercisable on 30 September 2009 to buy 10,000 shares in Oakway plc, a company quoted on the London Stock Exchange, for 220p a share. The company pays a premium of £1,000 for the option.

Suppose that on 30 September 2009, Oakway shares are trading at 202p. Clearly the company will not want to exercise the option because it could buy the shares for less in the market. The option is out of the money. The company has lost the £1,000 premium which it paid.

On the other hand, if the market in the underlying asset moves in their favour, the profit they could make by exercising the option is (theoretically) unlimited.

Example 2

When the option is written, Oakway shares are trading at 225p. The option is therefore described as being in the money - the agreed strike price of 220p is better than the benchmark of 225p. If the strike price had been agreed at 225p, the option would be at the money, while if the strike price were 230p, the option would be out of the money - someone exercising the option then and there would make a loss.

If the shares were trading at 230p, the company could exercise the option, buy 10,000 shares for £22,000 and then sell them in the market for £23,000, a ‘profit’ of £1,000. But the company has paid £1,000 for the option, so overall it has made neither gain nor loss. (In fact the overall outcome is unfavourable, because it has foregone any alternative investment return on the £1,000.)

But if Oakway shares were trading at 240p on 30 September, the company would make a profit of £1,000 after taking the option premium into account. And each additional 10p on the share price would mean an extra £1,000 of profit for Filnog Ltd.