©2007, The McGraw-Hill Companies, All Rights Reserved 10-1 McGraw-Hill/Irwin Buying call options  Assume a buyer pays $3 of investment cost for a call option to purchase a security at $100.  If the price of the security falls below $100 the contract will not be exercised and  the buyer will loose his original $3.

©2007, The McGraw-Hill Companies, All Rights Reserved 10-2 McGraw-Hill/Irwin Buying call options  If the security price is $103 there is still some loss or at least no gain after subtracting the investment cost of $3.  But if the price exceeds $103 the buyer will exercise the option.

©2007, The McGraw-Hill Companies, All Rights Reserved 10-3 McGraw-Hill/Irwin Buying call options If the price rises to $113, the buyer can either buy the security at the exercise price of $100 and resell it for $113 on the market or he can sell his option which will now have a worth of $13. Either way, he makes a profit of $10 on his $3 investment or a gain of over 300%!

©2007, The McGraw-Hill Companies, All Rights Reserved 10-4 McGraw-Hill/Irwin Buying Put Options Involves taking a short position and exercising 'the option should the underlying security price decrease. If the price declines sufficiently, the holder of a put option will either buy the security on the open market and sell it to the writer at the new higher price, or he will trade his option at a higher price.

©2007, The McGraw-Hill Companies, All Rights Reserved DIFFERENCES BETWEEN OPTIONS AND FUTURES CONTRACTS A.Options buyers have no obligation to perform; B.Options buyers pay premiums vs. margins for futures; C.Maximum loss to buyer is premium -- asymmetric risk McGraw-Hill/Irwin