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Related to options: Derivatives
Options contracts are used both in speculative investments, in which the option holder believes he/she can secure a price much higher (or lower) than the fair market value of the underlying on the expiration date. For example, one may purchase a call option to buy corn at a low price, expecting the price of corn to rise significantly by the time the option is exercised. The investors may then buy the corn at the agreed-upon low price and instantly resell it for a tidy profit. Cases in which the option holder is correct are called in the money options, while cases in which the market moves in the opposite direction of the speculation are called out of the money. Like all speculative investing, this is a risky venture.
Other investors use option contracts for a completely different purpose: to hedge against market movements that would cause their other investments to lose money. For example, the same corn investor may buy the commodity at fair market value with the hope of the price rising. He/she may then buy a put contract at a high price in case the price of corn declines. This will limit his/her risk: if the price of corn falls, the investor has the option to sell at a high price, and, if the price of corn rises (especially higher than the strike price of the option), then he/she will choose not to exercise the option. See also: Futures, Forward Sales.
Buying an option gives you the right to buy or sell a specific financial instrument at a specific price, called the strike price, during a preset period of time.
In the United States, you can buy or sell listed options on individual stocks, stock indexes, futures contracts, currencies, and debt securities.
If you buy an option to buy, which is known as a call, you pay a one-time premium that's a fraction of the cost of buying the underlying instrument.
For example, when a particular stock is trading at $75 a share, you might buy a call option giving you the right to buy 100 shares of that stock at a strike price of $80 a share. If the price goes higher than the strike price, you can exercise the option and buy the stock at the strike price, or sell the option, potentially at a net profit.
If the stock price doesn't go higher than the strike price before the option expires, you don't exercise. Your only cost is the money that you paid for the premium.
Similarly, you may buy a put option, which gives you the right to sell the underlying instrument at the strike price. In this case, you may exercise the option or sell it at a potential profit if the market price drops below the strike price.
In contrast, if you sell a put or call option, you collect a premium and must be prepared to deliver (in the case of a call) or purchase (in the case of a put) the underlying instrument. That will happen if the investor who holds the option decides to exercise it and you're assigned to fulfill the obligation. To neutralize your obligation to fulfill the terms of the contract before an option you sold is exercised, you may choose to buy an offsetting option.
optiona contractual right to buy (a ‘call’ option) or sell (a ‘put’ option) or buy/sell (a ‘double’ option) a FINANCIAL SECURITY such as a SHARE, FOREIGN CURRENCY, or a COMMODITY such as tea or tin, at an agreed (predetermined) price at any time within three months of the contract date. Option rights are purchased for a percentage of the share price etc. which varies according to the observed volatility of the share etc. (i.e. the magnitude of fluctuation in its price over the recent past).
Options are of two types: non-tradeable and tradeable. In the latter case the option itself can be bought and sold, which gives the option holder a greater degree of flexibility (see FORWARD MARKET); for example, if, in the case of a ‘put’ option, the share price should start to go down instead of up as anticipated, the option holder can cut his losses by selling his option. Options are frequently used to speculate (see SPECULATION) or hedge (see HEDGING) against future market prices.
The EUREX and the LONDON INTERNATIONAL FINANCIAL FUTURES EXCHANGE constitute the largest European Union centres for dealings in options and other forward contracts. See DERIVATIVE, SWAP. See also EXECUTIVE SHARE OPTION SCHEME.
optiona contractual right to buy or sell a COMMODITY (rubber, tin, etc.), a FINANCIAL SECURITY (share, stock, etc.) or a FOREIGN CURRENCY at an agreed (predetermined) price at any time within three months of the contract date. Options are used by buyers and sellers of commodities, financial securities and foreign currencies to offset the effects of adverse price movements of these items. For example, a producer of chocolate could purchase an option to buy a standard batch of cocoa at an agreed price of, say, £500 per tonne. If the market price of cocoa rises above £500 per tonne over the next three months before the option expires, then the chocolate producer will find it worthwhile to exercise his option to buy the cocoa at £500. If the price falls below £500, then the chocolate producer can choose not to exercise the option but instead to buy at the cheaper current market price. The chocolate producer pays, say, £50 for the buy or ‘call’ option in order to protect himself from significant price rises for cocoa (a sort of insurance against adverse price movements). Similarly, growers of cocoa can enter into a sell or ‘put’ option to cover themselves against falling cocoa prices. For example, if a cocoa grower enters into an option to sell a standard batch of cocoa at an agreed price of £500 per tonne and the price falls, he will exercise his option to sell at £500 per tonne, but if the price rises above £500 per tonne, he will choose to sell his cocoa at the higher market price and allow the option to lapse. The cocoa grower would pay, say, £50 for the sell or ‘put’ option in order to protect himself from significant price falls in cocoa. In between the buyers and producers of cocoa are the specialist dealers who draw up option contracts and decide option prices in the light of current and anticipated prices of cocoa.
In addition to options that are bought and sold to underpin a normal trading transaction, some options are bought and sold by speculators (see SPECULATION) seeking to secure windfall profits. Options are traded on the FUTURES MARKET, especially the LONDON INTERNATIONAL FINANCIAL FUTURES EXCHANGE.
The right to purchase or lease property for an agreed-upon price.The person who owns the property is called the optionor and is the one who grants the option.The recipient is called the optionee.The optionee has the right to take advantage of the opportunity, but does not have the obligation to do so.