What is Options?
An option is a type of financial instrument classed as derivatives because they derive their value from an underlying asset. An option gives its holder the right, but not the obligation, to buy or to sell some asset (In return for granting the option, the seller collects a payment (the premium) from the buyer. Granting the option is also referred to as “writing” the option. In many cases the option can be sold on by its original buyer, and this is why the distinction between the term “seller” and “writer” is useful when describing options. It is the writer who is the particular seller who must make good on delivering (or receiving) the underlying asset or its cash equivalent, not any seller.
Types of Options:The two types of options are calls and puts: A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires. People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date. For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility because of the versatility of options, there are many types and variations of options. Non-standard options are called exotic options, which are either variation on the payoff profiles of the plain vanilla. Working of stock options:Suppose the premium for an August 100 call of Company X currently trading at $90 is $5. The expiry of this option will be the third Friday of August. So, at $5 we are buying the right and not the obligation to purchase 1 share of X at $100. JUNE 92 (Stock price) 6 (premium) So, our net profit would have been profit on exercising options – option premium = $300-$500 = ($200). |