19 January, 2016
Option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction.
The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist and options can in principle be created for any type of valuable asset.
An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless.
In return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised.
An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized ad hoc to the desires of the buyer, usually by an investment bank.
As with all securities, trading options entails the risk of the option's value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlying and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict.
A call option entitles the buyer of the option the right to purchase the underlying security at the predetermined strike price on or before its expiration date. The option writer (the party that sells the option) is also of course obligated to sell the security under those same conditions. As the option's price increases and decreases according to the underlying stock, a trader will only buy a call option if the trader believes that the price will increase prior to the expiration date.
A put option is a contract that gives the buyer of the option the right to sell the underlying security at a particular price (strike price) on or before a certain date (expiration date). The seller (or writer) is, in turn, obligated to buy the security should the option owner decide to exercise the option. A put option's price increases when the underlying stock's price decreases, and decreases as the underlying stocks price increases. Hence, typically a trader will buy a put option for speculation if the trader expects a stock will go down before the option expires.
Opening and closing positions
There are two perspectives to opening and closing positions, the buyer perspective and the seller perspective. A party who is buying an option opens a position in the market with the purchase of the option and closes the position by selling the security. For sellers it works vice versa – positions are opened by selling a security and closed by purchasing the security back.
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