Option

What is an Option?

An option is a type of financial instrument or derivative that provides the holder with the right, but not the obligation, to either buy (call option) or sell (put option) an underlying asset at a predetermined price, known as the exercise or strike price, within a specified time period. Unlike future contracts, the option holder is not obligated to execute the transaction if it is not profitable. The maximum loss an option holder can incur is limited to the initial premium paid to purchase the option.

Types of Options

• Call Option: This gives the holder the right to buy an underlying asset at the strike price. It is often purchased when the buyer expects the asset’s price to rise.
• Put Option: This gives the holder the right to sell an underlying asset at the strike price. It is typically bought when the buyer expects the asset’s price to decline or to protect an existing investment from a potential loss.

American vs. European Options

• American Option: Can be exercised at any time before or on the expiration date, providing more flexibility and generally carrying a higher premium.
• European Option: Can only be exercised on the expiration date itself, which often makes them simpler to value but less flexible compared to American options.

Usage of Options

• Hedging: Investors use options to guard against the risk of price fluctuations in the underlying asset.
• Speculation: Traders use options to bet on the rise or fall of the price of the underlying asset with limited initial investment and potentially high returns.

Examples

1. Call Option Example:

   • An investor buys a call option for stock XYZ at a strike price of $100, expiring in three months, for a premium of $5. If XYZ’s price rises to $120 before expiration, the investor can exercise the option, buy the stock at $100 and sell it at $120, netting a profit (excluding the premium cost). If the price remains below $100, the investor will let the option expire, losing only the initial premium.

2. Put Option Example:

   • Similarly, if an investor believes stock ABC will decrease from its current price of $75, they might purchase a put option with a strike price of $70, for a premium of $3. If ABC falls to $60, the investor can sell it at $70, securing a profit (minus the premium cost). If the price stays above $70, the option will expire worthless, and the investor loses only the premium.

Frequently Asked Questions

What are the main components of an option?

• Strike Price: The price at which the underlying asset can be bought or sold.
• Expiration Date: The date on which the option expires.
• Premium: The cost to purchase the option.
• Underlying Asset: The security, commodity, currency, or other financial instrument on which the option is based.

How does an American option differ from a European option?

American options can be exercised at any time before or on the expiration date, whereas European options can only be exercised on the expiration date.

Can options be used for risk management?

Yes, options are commonly used for hedging to protect against potential losses in an investment portfolio.

What happens if an option expires worthless?

The holder loses the premium paid for the option, which is the initial and only financial risk involved.

What is a covered call?

A covered call is a strategy where an investor holds a long position in an asset and sells a call option on the same asset to generate additional income.

Related Terms

• Real Option: A choice available to a company regarding investment opportunities, often used in capital budgeting.
• Hedging: Strategies employed to protect against risks of price fluctuations.
• Speculation: The practice of engaging in risky financial transactions in an attempt to profit from fluctuations in the market.
• Premium: The cost that the buyer of the option pays to the seller.

Online Resources

1. Investopedia: Options Basics
2. CME Group: Options on Futures
3. SEC: Options Trading

Suggested Books

1. “Options, Futures, and Other Derivatives” by John C. Hull
   • Provides comprehensive coverage of various derivative instruments, including options.
2. “Option Volatility and Pricing” by Sheldon Natenberg
   • Excellent for advanced concepts in option pricing and volatility behavior.
3. “The Option Trader’s Hedge Fund: A Business Framework for Trading Equity and Index Options” by Dennis A. Chen and Mark Sebastian
   • Useful for practical options trading strategies.

Accounting Basics: “Option” Fundamentals Quiz

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