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"An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date"Option definition
Call options give the option to buy at certain price, so the buyer is betting on the price going up.
Put options give the option to sell at a certain price, so the buyer is betting on the price going down.
Options are types of financial derivatives. A financial derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties and its value is determined by the price of the underlying asset.
Most options are created in a standard format and can be traded on public option exchanges. You may come across some options that are traded Over-The-Counter, also known as OTC, these option contracts will normally have non-standard elements and are not traded on an exchange.
The price at which the underlying asset may be exercised is called the strike price or exercise price. The process of triggering an option and thereby trading the underlying asset at the agreed price is known as exercising it. If the option is not exercised by the expiration date, it becomes void and worthless.
In return for assuming the obligation the writer 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.
Options are contracts between two parties and the terms are detailed in an option term sheet. Options have multiple elements and can range from standard to very complicated. Below outlines some items you will see mentioned on an Option term sheet.
Over-the-counter options are not listed on an exchange but traded between two private parties. Are sometimes referred to as 'dealer options'. Terms for an OTC are unlimited and can be tailored around investment needs of the parties involved. On most occasions one of the parties is usually a large institutions like a bank or brokerage house. Option types commonly traded over the counter include:
Below naming conventions are used to help identify properties common to many different styles of option along with their unique features:
Options are typically traded in standard contracts on several futures and options exchanges. The Chicago Board Options Exchange (CBOE) is an example of an options exchange. Each standard option contract will have a ticker symbol. This allows for buying and selling of options on the exchanges and providing valuation and pricing details to vendors. Trading of Over-The-Counter (OTC) option contracts does not occur on the exchanges mentioned above. Typically at least one counterparties in an OTC trade is a well-capitalised institution e.g. brokerage/bank. OTC options allow investors to define specific terms which may not be obtainable on standard option contracts. Another reason for choosing OTC contracts is because they are not advertised to the market there are very little regulatory requirements associated with them.
There are two ways you can trade options either as an option holder or an option writer. Below takes a look at the trades from both sides:
Long call: An investor who predicts a stock's price will increase may buy the right to purchase the stock (a call option) rather than just purchase the stock itself. There is no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium paid then the investor will realize a profit. If the stock price at expiration is lower than the exercise price then the investor will let the call contract expire worthless. The only loss on the trade will be the amount paid for the premium. An investor may buy the option instead of shares because they can gain a larger exposure without outlaying more cash. This is known as leverage.
Long put: An investor who predicts a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). They will be under no obligation to sell the stock but have the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid then the investor will realize a profit. If the stock price at expiration is above the exercise price they will let the put contract expire worthless and only lose the premium paid.
Short call: An investor who believes that a stock price will decrease can sell the stock short or instead sell or "write" a call option. The investor selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money. Because prices can only decrease to zero but can increase to any price the potential loss on a short call is unlimited.
Short put: An investor who believes that a stock price will increase can buy the stock or instead sell, or "write" a put option. The investor selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium the investor will lose money with the potential loss being up to the full value of the stock.
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