Options and future option trading wiki
Options can be confusing because they add another level of complexity to investing. They also have a unique terminology that must be mastered to understand what a particular option contract represents. Perhaps the most common misunderstanding for those new to options, is the idea that no shares of the underlying security change hands when an option is written or purchased; an option is nothing more than a contract between two parties. Options are a type of financial security, just like stocks , bonds and mutual funds , and can be bought and sold just as easily as one buys and sells stocks.
Options are known as derivative investments because their value is derived from the value of the underlying stock when buying or selling options on stocks or commodity when buying or selling options on commodity futures. Generally, options are used as a tool to make more leveraged investments in common securities.
Because they are less expensive than the underlying asset, relative percent return that can be achieved through options is significantly higher than on the underlying asset alone. The graph below shows just that. With the advent of low commission online brokers offering options, it is becoming easier to invest in options. This is a good thing for retail investors as it allows them to take advantage of the two main benefits of trading options: It is also a potentially dangerous situation since options, especially individual options, generally entail more risk than the underlying security and this risk is magnified when investors do not know how to invest in options appropriately.
The purpose of this guide is to educate investors on how options are priced and how to use options to augment one's current investment goals. Exercising the option - This is the buying or selling of the underlying asset via the option contract. Strike or exercise price - This is the fixed price in the option contract at which the holder investor can buy or sell the underlying asset e.
Expiration date - The maturity date of the option; the option doesn't exist after this date. Calls and puts are the two types of "plain vanilla" options, and most advanced option positions are constructed using a combination of calls and puts.
There are also two types of standard put and call options, known as American options and European options. The difference between the two has nothing to do with physical geography, but rather how and when the options can be exercised.
American options can be exercised anytime before the option contract expires, while European options can only be exercised on the expiration date. Options traded publicly on exchanges are nearly always American options, while options that are traded over the counter are mainly European options. For standard put and call options the payoff to the option holder is relatively simple.
Note that when talking about option payoffs it is convention to ignore the price of the option and consider only the amount of money the holder gets for holding the contract to maturity. The holder of a call option will only execute the option if, on maturity, the current price of the underlying asset is greater than the strike price.
If this is the case, the call holder can purchase shares at the strike price and sell shares at the market price, netting the difference as profit.
In the case that the strike price is greater than the price of the underlying asset at the time of maturity, the call option is worthless - the holder would prefer to purchase the asset at the current market price and thus would not exercise the option. The payoff of a plain-vanilla call option at maturity is,. The graph below shows the relationship between the payoff of a call option and the price of the underlying security at maturity. The holder of a put option has the right but not the obligation to sell shares of the underlying asset at the strike price upon maturity.
As such, it is only profitable for the holder to do so if they can sell the shares when the strike price is greater than the market price at maturity. The value of a put option at maturity is,. An option's value and payoff is directly related to the price and volatility of an underlying asset, as well as factors such as the proximity to the expiration date. Options can be valued using different valuation methods including the popular Black-Scholes Model which uses many variables to calculate the estimated value of an option.
When someone purchases 1 call option on a stock which expires in 1 year, the value of the option will increase as the underlying security rises in value.
At the same time, the option will slowly lose time value as time progresses and the option gets closer to the expiration date. The call contract price generally will be higher when the contract has more time to expire except in cases when a significant dividend is present and when the underlying financial instrument shows more volatility.
Determining this value is one of the central functions of financial mathematics. The most common method used is the Black—Scholes formula. Importantly, the Black-Scholes formula provides an estimate of the price of European-style options. Adjustment to Call Option: When a call option is in-the-money i. Some of them are as follows:. Similarly if the buyer is making loss on his position i. Trading options involves a constant monitoring of the option value, which is affected by the following factors:.
Moreover, the dependence of the option value to price, volatility and time is not linear — which makes the analysis even more complex.
From Wikipedia, the free encyclopedia. This article is about financial options. For call options in general, see Option law.
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