The payoff of an option is a relatively straightforward calculation based upon the type of the option and is derived from the price of the underlying security on expiry relative to the strike price. The formula for the call option payoff is as follows:
The formula for the put option payoff is as follows:
We will model both of these functions and visualize their payouts.
An option gives the buyer of the option the right to buy (a call option) or sell (a put option) an underlying security at a point in the future and at a predetermined price. A call option is basically a bet on whether or not the price of the underlying instrument will exceed the strike price. Your bet is the price of the option (the premium). On the expiry date of a call, the value of the option is 0 if the strike price has not been exceeded. If it has been exceeded, its value is the market value of the underlying security.
The general value of a call option can...