Introduction

Welcome to the module on “Properties of Options.” In this chapter, we will explore the foundational concepts and importance of understanding the properties of options in the world of finance. Options are powerful financial instruments that provide investors and traders with unique opportunities for risk management and profit generation. By delving into the factors that influence option prices, bounds for option values, put-call parity, and early exercise features, we aim to equip you with the knowledge necessary to make informed investment decisions and effectively manage your risk exposure.

Importance of Understanding Option Properties

Options are versatile tools used in various financial strategies, including speculation, hedging, and generating income. Gaining insight into the underlying principles that drive option pricing and behavior is crucial for making informed decisions. For instance, an investor looking to hedge against potential losses in their stock portfolio can use options to mitigate risk. Conversely, a trader aiming to profit from market volatility can employ options to capture price fluctuations without the same level of capital commitment as outright stock ownership.

Overview of the Module’s Learning Objectives

In this module, we will delve into several key aspects of option properties, each contributing to a comprehensive understanding of options trading and valuation:

• Factors Affecting Option Prices: Explore the six primary factors influencing option prices, including the underlying asset price, time to expiration, implied volatility, interest rates, dividends, and strike price. Learn how changes in these factors impact option values and the strategies that can be derived from such changes.

• Bounds for Option Prices: Understand the upper and lower bounds for option prices on both non-dividend and dividend-paying stocks. Discover how these bounds relate to market conditions and option features, providing insights into the range of potential option values.

• Put-Call Parity and Option Valuation: Uncover the concept of put-call parity, which establishes a relationship between call and put options with the same strike and expiration. Learn how to apply this principle to the valuation of European and American options, considering both dividend and non-dividend scenarios.

• Early Exercise Features of American Options: Dive into the rationale behind early exercise options and explore the decision-making process for American call and put options. Understand when it makes sense for an option holder to exercise their options prior to expiration and evaluate the potential benefits and drawbacks.

In the following chapters, we will delve into each of these learning objectives in detail, providing you with a comprehensive toolkit to navigate the world of option trading and valuation.