Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, buying a call option provides the right to buy a specified quantity of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract.
In short option types can be summarized as follows:
- A Call Buyer acquires the right to buy stock at exercise price.
- A Put Buyer acquires the right to sell the stock at exercise price.
- Long is the buying of a stock, with the expectation that the asset will rise in value.
- Short is the selling of a stock, with the expectation that the asset will fall in value.
The basic trades of traded stock options
These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging.
Long Call
A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares.
Short Call
A trader who believes that a stock price will decrease, can short sell the stock or instead sell a call. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.
Long Put
A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless and only lose his premium paid.
Short Put
A trader who believes that a stock price will increase can buy the stock or instead sell a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock.
Examples
1. A buyer of a call option expects the price of the stock to rise. It must be worthwhile to pay the premium price, for the stock appreciation payoffs at the end of the maturity. Given the strike price of 30p and call premium at 1.5p, the profit and loss graphic would be as follows:
At the time of exercising the option, anything that is above spot price + premium (30p + 1.5p) would yield in profit. And if stock value falls below the spot price then the loss will be limited to the premium price paid.
2. Seller (writer) of a put option has the obligation to buy the stock at the exercise price. The profit and loss profile graphic would be as follows for the strike price at 30p and premium put option price 2p.
As seen from the graphic the profit for a put writer is limited to 2p. However if the stock price at maturity time is below the spot price then seller of the put has to buy the stock at predetermined strike price. The loss may be as much as the price of the stock if its value falls to zero. Therefore it is the riskiest option among the other types. Seller of the put has to have a strong feeling that stock price will not fall or at least remain stable until the end of maturity.
3. Following graph illustrates the profit and loss profile by combining buyer of call and put options.
The sole buyer of a call option would start making profit after spot price + call premium (30p + 1.5p); whereas the sole buyer of put option would make profit if the stock price falls below the spot price – put premium (30p – 2p). The profit and loss profile of buyer of both would look like something as follows:
The maximum loss would be at spot price, when no change occurs at the stock value. This would be the sum of call and put option premiums. Any change from this point would start accumulate profit. If the Stock price exceeds 33.5p or falls below 26.5p, buyer would be able to avoid loss. Therefore any trader who buys combination of put and call option must expect swings in any direction. Stable stocks would not make much of a profit.
References
No comments:
Post a Comment