What is Options?

An option is a type of financial instrument classed as derivatives because they derive their value from an underlying asset. An option gives its holder the right, but not the obligation, to buy or to sell some asset (In return for granting the option, the seller collects a payment (the premium) from the buyer. Granting the option is also referred to as "writing" the option. In many cases the option can be sold on by its original buyer, and this is why the distinction between the term "seller" and "writer" is useful when describing options. It is the writer who is the particular seller who must make good on delivering (or receiving) the underlying asset or its cash equivalent, not any seller. Types of Options: The two types of options are calls and puts: A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires. People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date. For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility because of the versatility of options, there are many types and variations of options. Non-standard options are called exotic options, which are either variation on the payoff profiles of the plain vanilla. Working of stock options: Suppose the premium for an August 100 call of Company X currently trading at $90 is $5. The expiry of this option will be the third Friday of August. So, at $5 we are buying the right and not the obligation to purchase 1 share of X at $100. Cost of 1 option = $5. Cost of 1 contract = $ 5×100 = $500. The option will be exercised only when the share price goes above $100. We will breakeven at $100 + $5 (strike rate + premium) i.e. $105/option and $10500/contract. The share price and option price of the august 100 option of  X Co. after the end of June, July and on expiration is given below. JUNE                           92 (Stock price)                      6 (premium) JULY                           96 (Stock price)                      8  (premium) EXPIRATION               95 (Stock price)                  worthless We won't be able to exercise the option as the stock price has not gone above $100 till expiry. So, our loss is the amount of premium paid I.e. $500. In case the share prise on expiration was $103 then the option would have been exercised at the strike price of $100 and our profit per share would have been $3 (103-100). So, profit on exercising the option would have been $300. So, our net profit would have been profit on exercising options – option premium = $300-$500 = ($200).
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