Call & Option Terminology

[rajaar]

Hi David,

I am not very clear about the meaning of the terminology Short Call, Long call, Short Put, Long Put.

My existing knowledge is limited to a call and a put option, and that buyer of a call option can purchase in future and buyer of a put option can sell in future.

If you could please elaborate.

Regards
R

 

[David Harper CFA FRM]

Hi R

Sure, i like to imagine the counterparty. So if *you* are the option buyer, then you can imagine I am your counterparty.
In the case of a Euro call option, say I "write" or sell you a call option. Then at transaction (T0):

* You: buy the option, you are long, you pay the option premium
* Me: I collect option premium from you. I am short the call option

Later, if this is a call and the underlying price increases:

* You can exercise
* Since I am short, I need to receive your exercise price but deliver to you the full asset price. On a net basis, I am paying you the intrinsic value (= S-K)

If you do not exercise, and as the short option "writer" this was my original hope (i.e., I am short volatility, meaning i would prefer the asset just languish and let the option decay over time),

* no exericse
* as the long, you have lost your premium
* as the short, I have gained the same

...we can then extend this to *valuation* ... if we go further and treat the option itself as an instrument with value. Then:

* you hold the option, you are long, but even before exercise, if the asset price increases by +$1, your option increases by delta*$1*number of options you hold
* if i am short, the value of my position declines by the same

...finally, we are two counterparties, but you can visualize moving this to an exchange where the exchange is the "in between" counterpary

David