Types Of Options And Their Mechanics

There are two basic types of options. A CALL option gives the holder of the option the right to buy an asset by a certain date at the certain price. A PUT option give the holder the right to sell an asset at the certain time and at the certain price. The date specified in the contract is known as expiration date or maturity date. The price specified in the contract is called exercise price or strike price.

Options can be either American or European. This distinction has nothing to do with geographical locations. American options can be exercised at any time up to expiry, whereas European options can be exercised only at the expiration date specified. Most of the options traded on major exchanges are American options. However, European options are easier to analyse than American options, and some of properties of an American option are frequently deducted from those of its European counterpart.

CALL OPTIONS Consider the situation where an investor who buys a European call option with a strike price of $100 to purchase 100 shares of a certain stock. Suppose that the current stock price is $98, the expiration date of the option is in 4 months, and the price of an option to purchase one share is $5. The initial investment is $500. Because the option is a European option, the investor can exercise the option only at the expiration date. If the stock price at this date is less than $100, the investor will clearly choose not to exercise. Obviously there is no point in buying for $100 a share that has a market value less than $100. In this case the investor loses the whole of the initial investment $500. If the stock is above $100 at the expiration date, the option will be exercised. Suppose that the stock price is at $115. By exercising the option, the investor is able to buy 100 shares for $100 per share. If the shares are sold right away, investor makes a gain of $15 per share. When an initial cost of an option is taken into account, the net profit for the investor is $1000.

PUT OPTIONS Whereas the purchaser of a call option is hoping that the stock price will increase, the purchaser of the PUT OPTION is hoping that the price will decline in value. Consider an investor who buys a European put option with a strike price of $70 to sell 100 shares of a certain stock. Suppose that the current stock price is $65, the expiration date of the option is in three months, and the price of an option to sell one share is $7. The initial investment is $700. Because the option is European option, it will be exercised only if the stock price is below $70 on the expiration date. Suppose that the stock price is $55 on this date. The investor can buy 100 shares for $55 per share and, under the terms of the put option, sell the same shares for $70 to realize gain of $15 per share, or $1500. When the $700 initial cost of the option is taken into account, the investor's net profit is $800. There is no guarantee that the investor will make a gain. If the final stock price is above $70, the put option expires worthless and the investor loses $700. Early exercise

As already mentioned, exchange traded stock options are mostly American options rather than European options. This means that the investor in the forgoing examples would not have to wait until the expiration date before exercising the option. Options are great way to hedge investment and also widely used by businesses to protect their futures payments from value change over time.

The same principle apply to binary options industry. Binary options are more speculative derivatives. They offer an excellent opportunity to generate profits for smart investors.

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This article was published on 10 Jul 2014 and has been viewed 463 times
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