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Options Basics

Options

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All options qualify as derivative instruments. Derivatives acquire their value based on another asset which they represent. That asset is called the “underlying investment”. The underlying can be anything traded in the marketplace, as long as the underlying’s price is easily obtainable. Derivatives are often only traded during the same market hours as their underlying assets to ensure that’s possible. Derivatives neatly fit into two major categories, forwards or options.

Options, Yes or No?

Options are derivatives giving the purchaser the ability to take a conditional action before an expiration date. Note the word ability: if you have an option you have the right, but not the requirement, to take an action. Options should only be exercised if they result in profit. The profit is determined by the market price’s relation to the strike price. For an option to be exercised, the relation should be profitable.

An option is created when one party in the market decides to write the option. The option’s writer is the seller, and the buyer of the option in the market is the holder. The writer of an option is paid the premium, the purchase price of the option. The premium is paid by the option’s holder. The writer chooses the underlying asset and the conditional strike price. The potential buyer will choose to acquire the option based on whether they think the strike price is reachable. An option is called “in the money” if it is profitable. An option is “out the money” if it isn’t profitable. If the option is not exercised, the premium is profit for the writer and loss for the option holder. The profit for the option holder depends on the distance “in the money” of a call or put.

Option Types

A call option holder has the right to buy the underlying asset for the strike price, even if the underlying asset is worth more than the strike price. They haven’t bought the actual asset until they exercise the right to buy. A put option holder has the right to sell the underlying asset for the strike price, even if the underlying is worth less than the strike price. They haven’t sold the actual underlying until after they have exercised the right to sell. If the holder does exercise, the writer of a call must legally sell and the writer of a put must legally buy.

Expiration

Options don’t last forever. They will not be usable past their expiration date. After that date they’re worthless. Options which don’t exist cannot be traded or exercised. The date of expiry is given in the contract.

There are three styles of expiration for options. American Style options can be exercised at any date including on their expiration date. European options can be exercised only on their expiration date. Asian Style options can be exercised only if the average price between the writing of the option and the expiration date was above the exercise price.

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