Image via WikipediaThe U.S. Securities and Exchange Commission defines options as contracts that give purchasers the right to sell or buy securities like stocks within a given period at a fixed price. They are binding contracts whose properties and terms are strictly defined. Although the buyers have the right to sell or buy the securities, they are not obligated to do so.
When the period of an option passes, the contract becomes void. However, a purchaser makes an initial deposit that is not refunded in such an eventuality. On the other hand, the seller is obligated to sell the security in question at the agreed price if the buyer goes ahead with the purchase within the agreed timeframe.
Example
Perhaps someone wants to buy property for $500,000 but does not expect to get the money for 3 months. He gets into an option contract with the seller to make the purchase within 3 months and pays $5000. No matter how much the property’s value rises within the period, he will still buy it at the agreed price. If the buyer changes his mind, however, he will not be forced to buy the property but will lose the $5000.
The Basics
Call: This is the contract that provides the right to purchase a security within a given timeframe at an agreed price. Investors buying calls expect the values of the securities to rise within the agreed period.
Put: This option provides the right to sell a security within a specified timeframe at a given price. Investors buying puts expect prices to fall before the period agreed on expires.
This means the options trading market is primarily composed of 4 types of participants: buyers and sellers of calls and puts respectively. Option sellers are known as writers while the buyers are called holders. While holders are not obligated to go through with their contracts, writers are obligated to do so.
Strike Price: This is the agreed price at which a given security can either be sold or bought. If the share price is more than the strike price, the option is “in-the-money.”
Intrinsic Value: This refers to the amount of money by which a given option is in-the-money.
Premium: This is the total cost of an option.
Types and Styles of Options
Over-the-Counter options involve 2 private parties. They have unrestricted terms and do not get listed on exchanges.
Exchange-traded options are settled in a clearing house. They have standardized contracts that provide more accurate pricing models.
Option styles include American, European, Bermudan, Vanilla, Exotic and Barrier.
Investors use option trading for 2 primary purposes – hedging and speculation.
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