Information AboutOptions |
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In Finance , an option is a Contract whereby one party (the ''holder'' or buyer) has the right but not the obligation to exercise a feature of the contract (the option) on or before a future date (the exercise date or expiry). The other party (the ''writer'' or seller) has the obligation to honour the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the '''option premium'''. Most often the term "option" refers to a type of Derivative which gives the holder of the option the right but not the obligation to purchase (a "call option") or sell (a "put option") a specified amount of a Security within a specified time span. (Specific features of options on securities differ by the type of the Underlying instrument involved.) TYPES OF OPTION Historical Uses of Options Contracts similar to options are believed to have been used since ancient times. For example, Aristotle wrote about Thales, who bought the option to use olive presses during the next harvest. In the real estate market, call options have long been used to assemble large parcels of land from separate owners, e.g. a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the right — but not the obligation — to dramatize a specific book or script. Lines of credit give the potential borrower the right — but not the obligation — to borrow within a specified time period. Many choices, or embedded options, have traditionally been included in Bond contracts. For example many bonds are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early. ''Privileges'' were options sold over the counter in nineteenth century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was fixed at the market price on the day the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets. Real Options see main article: Real Options A real option is a choice that an investor has when investing in the real economy (i.e. in the production of goods or services, rather than in financial contracts). This option may be something as simple as the opportunity to expand production, or to change production inputs. Real options are an increasingly influential tool in Corporate Finance . They are typically difficult or impossible to trade, so lack the liquidity of exchange-traded options. Traded Options also called "Exchange-Traded Options" or "Listed Options" Traded Options are ; and are settled through a Clearing House (ensuring fulfillment.) Vanilla and Exotic Options Generally speaking a vanilla option is a 'simple' or well understood option, whereas an Exotic Option is more complex, or less easily understood. European Option s and American Option s on stock and bonds are usually considered to be "plain vanilla." Asian Option s, Lookback Option s, Barrier Options are often considered to be exotic, especially if the underlying instrument is more complex than simple equity or debt. THE OPTION CONTRACT For the option purchaser (also called the holder or taker), the option:
The counterparty (option writer / seller) has an obligation to fulfill the contract if the option holder exercises the option. In return, the option seller receives the option price or premium. OPTION FRAMEWORKS
OPTION PRICING MODELS Models of option pricing were very simple and incomplete until 1973 when Fischer Black and Myron Scholes published the Black-Scholes pricing model. Scholes received the 1997 Bank Of Sweden Prize In Economic Sciences (Nobel Prize of Economics) for this work, along with Robert Carhart Merton . In a departure from tradition, Fischer Black was specifically mentioned in the award, even though he had died and was therefore not eligible. The Black-Scholes model gives theoretical values for European put and call options on non-dividend paying stocks. The key argument is that traders could risklessly hedge a long options position with a short position in the stock and continuously adjust the hedge ratio (delta) as needed. Assuming that the stock price follows a random walk, and using the methods of Stochastic Calculus , a price for the option can be calculated where there is no arbitrage profit. This price depends only on 5 factors: the current stock price, the exercise price, the risk-free interest rate, the time until expiration, and the volatility of the stock price. The availability of a good estimate of an option's theoretical price contributed to the explosion of trading in options. Other option pricing models have since been developed for other markets and situations using similar arguments, assumptions, and tools, including the Black Model for options on futures, Monte Carlo Method s and Binomial Options Model s. In theory traders could buy cheap options and sell expensive options (relative to their theoretical prices), in quantities such that the overall delta is zero, and expect to make a profit. Nevertheless, implementing this in practice may be difficult because of "stale" stock prices, large bid/ask spreads, market closures and other symptoms of stock market illiquidy. If stock market prices do not follow a random walk (due, for example, to insider trading) this Delta Neutral strategy or other model-based strategies may encounter further difficulties. Even for veteran traders using very sophisticated models, option trading is not an easy game to play. OPTION USES One can combine options and other derivatives in a process known as Financial Engineering to control the risk in a given transaction. The risk taken on can be anywhere from zero to infinite, depending on the combination of derivative features used. Note, by using options, one party transfers (buys or sells) risk to or from another. When using options for insurance, the option holder reduces the risk he bears by paying the option seller a premium to assume it. Because one can use options to assume risk, one can purchase options to create Leverage . The payoff to purchasing an option can be much greater than by purchasing the underlying instrument directly. For example buying an at-the-money call option for 2 monetary units per share for a total of 200 units on a security priced at 20 units, will lead to a 100% return on premium if the option is exercised when the Underlying security's price has risen by 2 units, whereas buying the security directly for 20 units per share, would have led to a 10% return. The greater leverage comes at the cost of greater risk of losing 100% of the option premium if the underlying security does not rise in price. Other instruments to manage risk or to assume it include: Employee Stock Option s are also widely used as a compensation vehicle for employees and, in particular, senior executives of publicy traded corporations. However, employee stock options use is being curbed thanks in part to a decision by the Financial Accounting Standards Board (FASB) requiring that stock option grants are recorded on the income statement as an expense. Previously, options granted with fair market value exercise prices were not considered to have a cost to the company. This was a significant factor in their ascendancy as a compensation tool. The Basic Option Trades These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. ;Long Call :A trader who believes that a stock's price will increase may buy the right to purchase the stock (a Call Option ) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiry date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares. ;Short Call (''Naked'' short call) :A trader who believes that a stock's price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader 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. A trader who already owns the shares which he may be required to provide, and sells call options for those shares, has sold a Covered Call . ;Long Put :A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiry date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless. ;Short Put :A trader who believes that a stock's price will increase can sell the right to sell the stock at a fixed price. This trade is generally considered inappropriate for a small investor. If the stock price increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the premium, the short position will lose money. Introduction to Option Strategies Combining any of the four basic kinds of option trades (possibly with different exercise prices) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.
Long the stock, short a call. This has essentially the same payoff as a short put.
Long a call and long a put with the same exercise prices (a long straddle), or short a call and short a put with the same exercise prices (a short straddle).
Long a call and long a put with different exercise prices (a long strangle), or short a call and short a put with different exercise prices (a short strangle).
Long a call with a low exercise price and short a call with a higher exercise price, or long a put with a low exercise price and short a put with a higher exercise price.
Short a call with a low exercise price and long a call with a higher exercise price, or short a put with a low exercise price and long a put with a higher exercise price.
Butterflies require trading options with 3 different exercise prices. Assume exercise prices X1 < X2 < X3 and that (X1 + X3) /2 = X2 Long butterfly - long 1 call with exercise price X1, short 2 calls with exercise price X2, and long 1 call with exercise price X3. Alternatively, long 1 put with exercise price X1, short 2 puts with exercise price X2, and long 1 put with exercise price X3. Short butterfly - short 1 call with exercise price X1, long 2 calls with exercise price X2, and short 1 call with exercise price X3. Alternatively, short 1 put with exercise price X1, long 2 puts with exercise price X2, and short 1 put with exercise price X3.
Any combination of options that has a constant payoff at expiry. For example combining a long butterfly made with calls, with a short butterfly made with puts will have a constant payoff of zero, and in equilibrium will cost zero. In practice any profit from these spreads will be eaten up by commissions (hence the name "alligator spreads"). SEE ALSO Related: Call Option , Put Option , Moneyness , Option Time Value , Put-call Parity , Black-Scholes , Black Model , Binomial Options Model , Volatility Smile , Option Adjusted Spread Options: Stock Option , Warrant , Foreign Exchange Option , Bond Option , Options On Futures , Swaption , Interest Rate Cap And Floor , Credit Default Option , Binary Option , Real Option , Option (films) Finance articles: Derivatives Market , Financial Mathematics , Financial Economics , Finance , List Of Finance Topics , List Of Finance Topics (alphabetical) , Volatility Index EXTERNAL LINKS |
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