Apr
13

## What You Need to Know About Option as A Beginner Part II

A follow up of yesterday's introductory article What You Need to Know About Option as A Beginner Part I (last one on this topic).

a) Call option

It is the option to buy shares of stock at a specified time in the future. Often it is simply labeled a "Call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). Whereas the seller is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.

For example, let's look at a call option contract at a strike price of $100 for a given stock. Let's use the current month for this example. Let your requirement be to buy 100 shares of the stock which is currently trading at $110/share. And you are buying those stocks, not by the way of options, then you would be paying $11000 for the 100 shares. This means that you will be losing around $1000 for buying the stocks. But if you were to use this option contract and if it were to expire at the same stock price of 110/share then you would have the option to buy 100 shares of that stock at $100/share. Thus you can have a profit of $1000; which is nothing but the cost to buy the option. Here in this, lets hope that the stock at the time of expiration will be, say, $115/share and so you would end up making $500 over what your option costs were. But of course, if the stock price drops to $105/share then you will end up losing $500 on the deal, which will be the bad part of it.

The option value, and therefore price, varies with the underlying price and with time. The call price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expire and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula (which discussed before). Whatever the formula used, the buyer and seller must agree on the initial value (the premium), otherwise the exchange (buy/sell) of the option will not take place.

b) Put option

A contract between two parties, the writer (seller) and the buyer of the option. The buyer acquires a short position by purchasing the right to sell the underlying instrument to the seller of the option for specified price (the strike price) during a specified period of time.

Let’s look at the same example discussed for ‘Call option’, like you want to buy an put option contract at a strike price of $100 for a given stock. If the current value for the stock is $90/share and you wanted to buy the $100 put option contract you would probably be looking at a price of $10 or $11 in the option price listing. If the stock value doesn’t get increased in the period of your put option contract, then you would get a profit of $10/share. But in the other case, where the share value increases beyond $100, say by $10, then you would face a lose of $10/share. And for this put option, it is always advisable to exercise the contract if the current stock value is greater than your contract value. So that you can have a profit, else if you let it expire then you would end up paying the premium to the writer unnecessarily.

Future Value

From the above example for both the “call” & “put” option contracts, you would have got an idea that calculating the future value of the option. Thus in order to understand option pricing, this future value additive must be accounted for in your investment plan. Remember the longer you hold onto an option (call or put), the less valuable is that future value portion.

Again, Check Varieties of programming codes on option valuation for implementation.

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Why doesn’t the choice of performance measure matter?

a) Call option

It is the option to buy shares of stock at a specified time in the future. Often it is simply labeled a "Call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). Whereas the seller is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.

For example, let's look at a call option contract at a strike price of $100 for a given stock. Let's use the current month for this example. Let your requirement be to buy 100 shares of the stock which is currently trading at $110/share. And you are buying those stocks, not by the way of options, then you would be paying $11000 for the 100 shares. This means that you will be losing around $1000 for buying the stocks. But if you were to use this option contract and if it were to expire at the same stock price of 110/share then you would have the option to buy 100 shares of that stock at $100/share. Thus you can have a profit of $1000; which is nothing but the cost to buy the option. Here in this, lets hope that the stock at the time of expiration will be, say, $115/share and so you would end up making $500 over what your option costs were. But of course, if the stock price drops to $105/share then you will end up losing $500 on the deal, which will be the bad part of it.

The option value, and therefore price, varies with the underlying price and with time. The call price must reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time to expire and with a more volatile underlying instrument. The science of determining this value is the central tenet of financial mathematics. The most common method is to use the Black-Scholes formula (which discussed before). Whatever the formula used, the buyer and seller must agree on the initial value (the premium), otherwise the exchange (buy/sell) of the option will not take place.

b) Put option

A contract between two parties, the writer (seller) and the buyer of the option. The buyer acquires a short position by purchasing the right to sell the underlying instrument to the seller of the option for specified price (the strike price) during a specified period of time.

Let’s look at the same example discussed for ‘Call option’, like you want to buy an put option contract at a strike price of $100 for a given stock. If the current value for the stock is $90/share and you wanted to buy the $100 put option contract you would probably be looking at a price of $10 or $11 in the option price listing. If the stock value doesn’t get increased in the period of your put option contract, then you would get a profit of $10/share. But in the other case, where the share value increases beyond $100, say by $10, then you would face a lose of $10/share. And for this put option, it is always advisable to exercise the contract if the current stock value is greater than your contract value. So that you can have a profit, else if you let it expire then you would end up paying the premium to the writer unnecessarily.

Future Value

From the above example for both the “call” & “put” option contracts, you would have got an idea that calculating the future value of the option. Thus in order to understand option pricing, this future value additive must be accounted for in your investment plan. Remember the longer you hold onto an option (call or put), the less valuable is that future value portion.

Again, Check Varieties of programming codes on option valuation for implementation.

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