What is an option contract? An options contract is an agreement between two parties to facilitate a potential transaction involving an asset at a predetermined price and date. Call options can be purchased as a leveraged bet on the valuation of an asset, while put options are purchased to profit from price drops. Buying an option provides the right, not the obligation, to buy or sell the underlying asset.
Options are financial instruments based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell the selected underlying asset within a specified time frame or expiration date, at a price specified in the contract, depending on the type of contract they hold.
The terms of an options contract specify the underlying security, the price at which that security can be traded (the strike price), and the expiration date of the contract. In the case of stocks, a standard contract covers 100 shares, but the share amount can be adjusted for stock splits, special dividends or mergers.
Options are generally used for hedging purposes but can also be used for speculation. Options usually cost a fraction of the cost of the underlying asset. Exercising options is a form of leverage that allows an investor to bet on an asset without having to buy or sell the assets directly. In exchange for this privilege, the option buyer pays a premium to the option seller.
Option types…
· American…
An American type option is a version of an option contract that allows holders to exercise their option rights at any time, including on the expiry date.
An American-style option allows investors to take profits as soon as the stock price moves positively and also benefit from dividend announcements.
Most exchange-traded options on single stocks tend to be American, while options on indices tend to be European-style.
o Call and put options…
A long call option gives the holder the right to demand delivery of the underlying security or stock any day during the contract period. This attribute includes any day up to the due date and the due date. As with all options, the buyer has no obligation to buy the shares and does not have to exercise his right. The strike price remains at the same stated value throughout the contract.
If an investor purchased a call option in March for a company that expires at the end of December of the same year, he or she will have the right to exercise the call option at any time until maturity.
American put options also allow exercise at any point, including the expiration date. This capability gives the buyer the freedom to require the seller to take delivery of the underlying asset when the price falls below the stated strike price.
One reason for early implementation has to do with the cost of carrying or the opportunity cost associated with not investing in the gains from the put option. When the put is executed, investors are immediately paid the strike price. As a result, the proceeds can be invested in another security to earn interest.
However, the downside to using shares is that the investor misses out on any dividends as they will sell the shares. Also, the option itself may continue to appreciate if held until expiration, and early exercise could result in further gains being missed.
American Option Pros and Cons… Source: Investopedia
· European…
A European option is a version of an option contract that limits its execution to the expiration date. In other words, if the price of the underlying security, such as a stock, has moved, the investor cannot exercise the option early and buy or sell the shares. Instead, the buy or sell transaction will only occur on the option's expiry date.
European options define when option contract holders can exercise their contractual rights. The option holder's rights include buying the underlying or selling the underlying at the specified contract price (the strike price). In European type options, the holder can exercise his rights only on the day of expiry. As with other versions of options contracts, European options come with an upfront cost: the premium.
It is important to note that investors generally have no options to buy either the American or the European option. Certain stocks or funds may only be offered in one edition or the other, and not both. Most indices use European options as they reduce the amount of accounting required by the brokerage firm.
o Call ve put options…
A European call option entitles its holder to the underlying security at maturity. For an investor to profit from a call option, the stock's price at expiry must be trading sufficiently above the strike price to cover the cost of the option premium.
A European put option allows the holder to sell the underlying security at maturity. For an investor to profit from a put option, the stock's price at expiry must be trading sufficiently below the strike price to cover the cost of the option premium.
Many investors do not like to wait for an European option to expire. Instead, investors can sell the option contract back to the market before it expires.
Option prices vary according to the movement, volatility and time to maturity of the underlying asset. As a stock's price rises or falls, the value of the option—represented by the premium—increases and decreases. If the current option premium is higher than the premium they originally paid, investors can remove their option positions early. In this case, the investor will receive the net difference between the two premiums.
Closing the option position before expiration means that the trader is getting any gain or loss from the contract. An existing call option can be sold early if the stock rises significantly, while a put option can be sold if the stock price falls.
The early expiry of an European option depends on prevailing market conditions, the value of the premium - its intrinsic value - and the time value of the option - the time remaining before a contract expires. If an option is close to expiration, an investor is unlikely to gain much by selling the option early because there is little time left for the option to make money. In this case, the value of the option is based on its intrinsic value, which is a default price depending on whether the contract is inside, outside, or at the money (ATM).
European Option Pros and Cons… Source: Investopedia
In the money, out the money, at the money…
· In (at profit)…
A put option is said to be in profit when the strike price is higher than the market price of the underlying security.
· Out (at loss)…
A put option has a strike price that is lower than the market price of the underlying asset.
· At (neither profit nor loss)…
At the money (ATM) is a situation where the strike price of an option is the same as the current market price of the underlying security
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