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Finology Tips - The Basic Working of Options

by Rozzy S. Marketing Analyst

An option is a derivative contract that gives its owner the right to buy or sell securities at an agreed price within a specified period of time. Here's what all of these terms mean:

  1. Option: you pay for the option, or right, to make the deal you want. You are under no compulsion to do so.

  2. Agreed price: known as the strike price. It does not modify eventually, come what may happen to the inventory price. It has this name because you will hit when the original cost makes you money.

  3. Derivative: the option derives its value from the value of the underlying asset. This fundamental cost is one of the determinants of the option price.

  4. Certain periods: this is the time until the combined date, known as the due date. That's when your option expires. You can train your option at the hit price at any time until the ending date. In Europe, you can only exercise it exactly on the due date.

There are basically 2 types of options:

Call Option

Call options are financial contracts that give the option buyer the right, but not the obligation, to buy shares, bonds, commodities or other assets or instruments at a specified price within a specified period of time. The stock, security or commodity is called the underlying asset. A call purchaser proceeds when the fundamental asset increases in cost.

A call option can be contrasted with a sale, which gives the holder the right to sell the underlying asset at a price specified before or at maturity.

Main Points

  1. A call is an option contract that gives the owner the right, but not the obligation, to purchase a specified amount of an underlying security at a specified price, within a specified time.

  2. The particular price is known as the hit price and the particular time during which the sale is made in the maturity.

  3. Call options can be bought for speculation or sold for revenue. They can also be combined for use in spread or combination strategies.

Example

A single call option contract may give the holder the right to purchase 100 shares of Dell for Rs 100 by the three-month expiration date. There are many ending dates and hit prices for traders to choose from. As the value of Dell's shares increases, the price of the option contract increases and vice versa. The buyer of the call option may keep the contract until the expiration date, when he can receive the 100 shares or sell the options contract at any time before the ending date at the market price of the agreement at that moment.

Put Option

A put option is a contract that gives the owner the right, but not the obligation, to sell or short sell a specified amount of an underlying security at a predetermined price, within a specified period of time. The predetermined price at which the put option buyer can sell is called the strike price.

Put options are traded on a number of underlying assets, including stocks, currencies, bonds, commodities, futures and indices. A put can be contrasted with a call option, which allows the holder to buy the underlying at a specified price before or after maturity. They are critical to understanding when choosing whether to straddle or strangle.

Main Points

  1. Option holders have the right, but not the obligation, to sell a specified amount of an underlying security at a specified price, within a specified period.

  2. Put options are available on a wide range of assets, including stocks, indices, commodities and currencies.

  3. Put option prices are affected by the price of the underlying asset and the deterioration of time. They rise in worth as the fundamental asset falls in price and lose value as the ending time approaches.

Example

A put option becomes more valuable as the price of the underlying shares decreases. On the other hand, a put option loses its value as the underlying stock increases. Since put options, when exercised, provide a short position in the underlying asset, they are used for hedging purposes or to speculate on the downward price action.

Investors often use put options in a risk management strategy known as a protective sale. This policy is used as a form of asset insurance to make sure that losses on the fundamental asset do not go beyond a certain amount, that is, the hit price.

Working of options

Options are a versatile financial product. These contracts involve a buyer and a seller, in which the buyer pays a premium for options for the rights granted by the contract. Every call option has a bullish seller and a bearish buyer, while put options have a bearish seller and a bullish buyer

Investors and Traders will buy and sell options for several reasons. Option speculation allows an operator to maintain a leveraged position on an asset at a lower cost than buying shares in the asset. Investors will use options to protect or reduce their portfolio's risk exposure. In some cases, the option holder may generate revenue when he buys call options or becomes an option writer.

Some Options can be exercised at any time before the option's expiration date, while other options can only be exercised on the expiration date or the exercise date. Exercising means using the right to sell or buy the original security.

Summary

The less time there is until maturity, the lower the value of an option. This is because the chances of a price movement in the underlying stock decrease as we approach maturity. That is why an option is a wasted asset. If you buy a month-long option that is out of cash and the stock doesn't move, the option will become less valuable with each passing day. Since time is a component of the price of an option, a one-month option will be less valuable than a three-month option. This is because, with more time available, the probability of a price movement in your favor increases and vice versa. Author: Ausaf Ahmed



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About Rozzy S. Innovator   Marketing Analyst

17 connections, 0 recommendations, 53 honor points.
Joined APSense since, August 22nd, 2017, From New York, United States.

Created on May 6th 2020 01:49. Viewed 207 times.

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