|
|
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.
An option, just like a stock
or bond, is a security.
It is also a binding contract
with strictly defined terms
and properties.
Still confused? The idea
behind an option is present
in many everyday situations.
Say for example you discover
a house that you'd love
to purchase. Unfortunately,
you won't have the cash
to buy it for another three
months. You talk to the
owner and negotiate a deal
that gives you an option
to buy the house in three
months for a price of Rs1,000,000.
The owner agrees, but for
this option, you pay a price
of Rs30,000.
Now, consider two theoretical
situations that might arise:
1. It's discovered that
the house is actually the
true birthplace of Charlie
Chaplin! As a result, the
market value of the house
skyrockets to Rs10,000,000.
Because the owner sold you
the option, he is obligated
to sell you the house for
Rs1,000,000. In the end,
your profit is Rs89,70,000
(Rs10,000,000 - Rs1,000,000
- Rs30,000).
2. While touring the house,
you discover not only that
the walls are chock-full
of asbestos, but also that
the ghost of Chengez Khan
,haunts the master bedroom;
furthermore, a family of
super-intelligent rats have
built a fortress in the
basement. Though you originally
thought you had found the
house of your dreams, you
now consider it worthless.
On the upside, because you
bought an option, you are
under no obligation to go
through with the sale. Of
course, you still lose the
Rs30,000 price of the option.
This example demonstrates
two very important points.
First, when you buy an option,
you have a right but not
the obligation to do something.
You can always let the expiration
date go by, at which point
the option is worthless.
If this happens, you lose
100% of your investment,
which is the money you used
to pay for the option. Second,
an option is merely a contract
that deals with an underlying
asset. For this reason,
options are called derivatives,
which means an option derives
its value from something
else. In our example, the
house is the underlying
asset. Most of the time,
the underlying asset is
a stock or an index.
Calls
and Puts
The two types of options
are calls and puts:
A
call
gives the holder the right
to buy an asset at a certain
price within a specific
period of time. Calls are
similar to having a long
position on a stock. Buyers
of calls hope that the stock
will increase substantially
before the option expires.
A
put gives the holder the
right to sell an asset at
a certain price within a
specific period of time.
Puts are very similar to
having a short position
on a stock. Buyers of puts
hope that the price of the
stock will fall before the
option expires.
Participants
in the Options Market
There are four types of
participants in options
markets depending on the
position they take:
1.
Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
People who buy options
are called holders and
those who sell options
are called writers; furthermore,
buyers are said to have
long positions, and sellers
are said to have short
positions.
Here is the important
distinction between buyers
and sellers:
-Call holders and put
holders (buyers) are not
obligated to buy or sell.
They have the choice to
exercise their rights
if they choose.
-Call writers and put
writers (sellers) however
are obligated to buy or
sell. This means that
a seller may be required
to make good on their
promise to buy or sell.
Don't
worry if this seems confusing--it
is. For this reason we
are going to look at options
from the point of view
of the buyer. Selling
options is more complicated
and can thus be even riskier.
At this point it is sufficient
to understand that there
are two sides of an options
contract.
To
trade options, you'll
have to know the terminology
associated with the options
market.
The
price at which an underlying
stock can be purchased
or sold is called the
strike price. This is
the price a stock price
must go above (for calls)
or go below (for puts)
before a position can
be exercised for a profit.
All of this must occur
before the expiration
date.
For
call options, the option
is said to be in-the-money
if the share price is
above the strike price.
A put option is in-the-money
when the share price is
below the strike price.
The amount by which an
option is in-the-money
is referred to as intrinsic
value.
The
total cost (the price)
of an option is called
the premium. This price
is determined by factors
including the stock price,
strike price, time remaining
until expiration (time
value), and volatility.
Because of all these factors,
determining the premium
of an option is complicated
and beyond the scope of
this tutorial.
Options
Practical Approach: How
to implement? >>
Best
of Luck!
From
Bookprofit.com
Team
|
