In the tutorial on risk management applications of options, we will look at how various options strategies can be used for managing risk in a company. Before we start let’s review the key notations used in options formulas:
Time 0 refers to the time when an options strategy is initiated
Time T refers to the time the option will expire
T – 0 is the time to expiry
t is the current time
S refers to the spot price. So, S0 is the price at time 0. ST is the price at time T.
X is the exercise or strike price
c is the call price. Small c is for European calls and capital C is for American calls.
p is the put price. Small p is for European puts and capital P is for American puts.
r is the risk-free rate
p is the profit
When we measure profit in an option transaction, we will consider only the final value minus the initial pay out (premium). We will not take into consideration the risk involved or the time value of money.