Option

From Traderpedia

Definition:
The right to either buy or sell a security, commodity or financial instrument at a specified price, but no obligation to buy or sell during a specified time period.


The seller of the option is referred to as the writer, who takes on the obligation to fulfill the contract if executed by the purchaser.

Contents

[edit] Types of Options

Call: An option to purchase or enter in to a long position. For example an IBM 110 call would give the owner the right to purchase IBM from the option writer at 110.

Put: An option to sell or enter in to a short position. For example a Microsoft 50 put would give the owner the right to sell Microsoft to the option writer at 50.

A good way to remember is that you can "call the market up" ie buy a call when you're bullish or "put it down" ie buy a put when bearish.

[edit] Options Styles

European: Options which can only be exercised at expiration.

American: Options which may be exercised any time up to expiration.

Bermudan: Options which can be exercised only on prespecified days during the life of the option

[edit] Option Nomenclature

At-the-Money: An option which has a strike price very close to the current market price of the underlying instrument.

In-the-Money: An option with a strike price below the current market price for a call, or above it for a put. The idea is that if the holder were to exercise at that moment, he/she would be able to make an immediate profit. An in-the-money option, therefore, has intrinsic value.

Out-of-the-Money: An option with a strike price above the current market price for a call, or below it for a put. The idea is that if the holder were to exercise at that moment, he/she would be in a lossing situation.

Deep in the money option

Deep out of the money option

LEAPS: Long-term equity anticipation securities. These are equity options with expiries from 9 months to 3 years away.

Option chain

Option cycle

Naked option

Called away

[edit] Uses for Options

The advantage of options is that they can allow a trader to take very specific positions in the market. For example, one could take a position based on the idea that the market will move above X, but not higher than Y. By combining options with positions in the underlying instrument, one can create a wide array of profit/loss profiles.

[edit] Option Strategies

  • Bear
    • Very bearish: Buy puts
    • Moderately bearish and certain market won't rise: Sell calls
    • Moderately bearish and fairly certain market won't rise: Bear spread
    • Bullish short term and bearish in the longer term: Diagonal put spread
    • Hold stock and bearish on it: Put hedge

[edit] Additional strategies

[edit] Option Pricing

Option pricing is based on several variables, the most important of which is volatility. Some of the models employed are listed below.

[edit] Black-Scholes

The Black-Scholes model is the most well known of the option pricing models, and the most pervasive if not in actual use, then at least in influence. The model is so ubiquitous that it is common practice for the implied volatility of an option to be quoted instead of its price. This is a reflection of the fact that volatility is the driving force in option pricing, and that all other inputs can be held even for a given time period.

[edit] Binomial

The binomial option model takes a different approach from Black-Scholes. It operates in a tree fashion. At each discrete point in time a probability is determined for up and down as well as the scale of price changes. This is extended through the duration of the option producing a series of possible price points for the underlying security and the probability associated with each. The option price is then derived from those price/probability calculations.

The binomial model has become popular because this approach is able to handle a variety of conditions for which other models cannot easily be applied. (For example, to value American options which can be exercised at any point). Also, application of the model relatively simple, mathematically, so it can be implemented in a software environment.

[edit] Option pricing terms

[edit] Options Exchanges

[edit] Related T2W Resources