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An option is a contract that represents the right to buy call option or sell put option a specified amount of an underlying security at a predetermined fixed price within a specified time period.
The underlying securities typically are shares of stock or exchange-traded funds, securities indexes, bonds or foreign currencies. The fixed price or "strike price" is the price at which the underlying security can be purchased, in the case of a call option, or sold, in the case of a put option. The purchaser or holder of an option pays a premium for the right but not the obligation, to exercise the option contract.
At expiration, the option becomes worthless. Option sellers assume a legal obligation under the option contracts to fulfill the contracts if the options are assigned to them, whereas the premiums are the extent of the potential risk to option buyers. Options lose value with time - known as "time decay" - which is priced into the premium amount paid by the purchaser.
Options can be used in a variety of ways to profit from a rise or fall in the market. Buying an option offers limited risk and unlimited profit potential: Selling or writing an option, however, provides an obligation to perform if the party purchasing the option chooses to exercise.
Selling or writing an option therefore presents the seller with limited profit potential and significant risk unless the position is properly hedged. Sellers or writers of options typically expect the price of the underlying security to remain flat or move in the desired direction.
In return for their obligations, the writers receive an upfront cash payment or premium from the buyers. Options are traded on securities and commodities exchanges and through the over-the-counter "OTC" market. With respect to the trading of options on exchanges, the securities exchanges generally list and trade options on stocks, exchange-traded funds "ETFs" , bonds, trust issued receipts, other securities and foreign currencies.
Commodity exchanges generally list and trade futures contracts and options on futures contracts. Options directly based on an underlying security or securities are solely listed and traded on securities exchanges.
Standardized terms for exchange-traded securities options include size, expiration date, exercise style and exercise or strike price. The creation of the Options Clearing Corporation "OCC" when standardized securities options trading commenced in virtually eliminated counterparty risk i. OCC is the sole issuer and financial guarantor of all securities options traded by U.
In connection with the mechanics of listing standardized options contracts, the OCC together with the U. The term "options series" means all options of the same class listing identical terms, including the same expiration month.
There are two types of standardized or exchange-traded options - calls and puts. A call option gives the holder the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time period in exchange for a premium amount. The buyer of a call option hopes the price of the underlying security rises by the call's expiration date, while the seller hopes that the price of the underlying security remains flat or decreases.
A put option gives the holder the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time period in exchange for a premium amount. The buyer of a put option hopes the price of the underlying stock decreases by the expiration date, while the seller hopes the price of the underlying security remains flat or increases.
The strike price is the fixed price of the option contract at which the underlying security can be purchased call or sold put at any time prior to the option's expiration date if the option is exercised. The expiration date designates the last day on which an option may be exercised.
Standardized or exchange-traded options typically permit two 2 types of exercise: American-style options can be exercised at any time prior to expiration while European-style can be exercised only on the expiration date. Exchange-traded options have an expiration month and generally expire on the third Saturday of the expiration month.
A third form of exercise, which is occasionally used with over-the-counter "OTC" options, is Bermudan exercise. The premium amount represents the actual price an investor pays to purchase an option or receives for selling an option. The "bid" is the highest price a potential buyer will pay for the option while the "ask" is the lowest price acceptable to a potential seller.
The "ask" and "bid" prices are known as "quotes," which are disseminated by the options exchanges through the Options Price Reporting Authority "OPRA" with the difference between the bid and ask known as the "bid-ask spread. The pricing of options contracts is complex. Although developed in the early 's, this pricing model remains the basic pricing framework for option practitioners.
In subsequent years, several variations from the Black-Scholes Options Pricing Model have been developed to directly address varying assumptions and scenarios. The major components affecting the price or premium are the current price of the underlying security, the type of option, the strike price compared to the current market price of the underlying security, the amount of time remaining to expiration, the volatility of the underlying security and interest rates.
The premium amount is generally the intrinsic value strike price minus current value of the underlying security plus time value. The intrinsic value of an option measures the amount that the option is "in-the-money" as compared to the strike price. The intrinsic value of a call option is thus the market price of the underlying securities minus the strike price of the option, and the intrinsic value of a put option is the strike price minus the market price.
The time value portion of the premium depends on the volatility of the underlying security. Volatility is a measure of the amount by which an underlying security is expected to fluctuate in a given period of time. Options of stocks that are volatile generally require a higher premium due to the greater inherent risk.
Option contracts are a form of derivative instrument. A derivative instrument or derivative is a financial instrument which derives its value from the value of some other asset or variable.
For example, a stock option is a derivative because it derives its value from the value of an underlying stock. Derivatives are known or divided into two 2 types: Plain vanilla derivatives generally provide for simple structures, while exotic derivatives generally provide for more complicated structures that are specifically tailored to an individual need, strategy, or situation.
Accordingly, plain vanilla derivatives are typically more common and represent a greater share of the derivatives marketplace as compared to exotics. Derivative instruments are further categorized in various ways. One distinction is between linear and non-linear derivatives.
The former have payoff amounts that behave like a line, as shown in Figure 1. The latter have payoff diagrams with curvature, either convex or concave, as shown in Figure 2, or have more complex payoff diagrams, such as that shown in Figure 3. In addition, a non-linear derivative may have gaps in the payoff profile. Certain derivatives provide for the purchase or sale of an underlying asset.
A typical standardized or exchange-traded option contract in the United States represents the right to purchase or sell shares of an underlying asset. This type of option is typically said to have a multiplier of , i. There is also variation in the method for settling option transactions. Options may be settled by delivery of the underlying asset "physical settlement" or by delivery of the cash value amount "cash settlement". A derivative instrument is physically settled if the underlying asset is to be delivered in exchange for a specified payment.
With cash settlement, the underlying asset is not physically delivered. Certain types of derivatives are routinely cash-settled because physical delivery would be inconvenient or impossible. An option on an interest rate must be cash-settled because an interest rate cannot be physically delivered.
One style of "exotic option" which is typically cash-settled is a binary option. Binary options also known as a "digital options" have a discontinuous or non-linear payoff, like that shown in Figure 3. There are many forms, but the two most basic are: Binary options can be European or American exercise style and can be structured as calls or puts.
A European cash-or-nothing binary pays a fixed amount of cash only if it expires in-the-money. For example, a European cash-or-nothing call makes a fixed payment if the option expires with the underlying asset above the strike price. It pays zero 0 if it expires with the underlying asset equal to or less than the strike price.
The value of the payoff is not affected by the magnitude of the difference between the underlying asset or index and the strike price. Accordingly, binary options are clearly within the category of derivatives with non-linear payoffs. For example, a binary call option at a strike price for the underlying asset of 75 would pay the same amount if, at expiration, the underlying asset price was at 76, 80, 85, 95 or any other price above In contrast, a standardized or exchange-traded call option in the money would pay different amounts based on each of those expiration prices, with the amounts increasing in a direct, linear relationship from the strike price.
A registered national securities exchange or designated contract market are hereinafter referred to collectively as "organized exchange. OTC derivatives are understood to be specifically tailored to the needs and requirements of the end-user, and therefore, lack the standardization and transparency found on organized exchanges. The majority of derivative products are traded OTC.
In such a market, large financial institutions serve as derivatives dealers, customizing products for the needs of particular clients. Contract terms are negotiated between the parties, and typically each party has only their contra-party to look to for performance of the contract.
Binary options have been traded for some time in an OTC environment between institutional traders but not on a national securities exchange.
Contract markets have offered "binary options" based on catastrophic events as well as on certain economic indexes such as the Consumer Price Index CPT. In France, Germany and Austria, binary options have been traded OTC in a one-sided market between investors and an institution.
The institution in these cases is the issuer of the contract and establishes, if applicable, the market for the binary option. OTC binary options have several drawbacks and disadvantages. One disadvantage is that OTC binary options are typically offered by an institution on a non-fungible basis so that a customer can purchase the option only from the institution, and cannot easily resell to a third party because they are not standardized or traded on an exchange.
As a result, OTC binary options, as compared to standardized exchange- traded options, lack important attributes of a trading market such as transparency and liquidity. An example of the organizational structure of an exchange such as those on which some options are currently traded is illustrated in Figure 4.
Typically, in the floor-based model, trading takes place at a "post" consisting of a "specialist" or designated market maker and trading crowd The American Stock Exchange "Amex" employs a modified specialist system. The specialist post is a specific location on the trading floor of the. Exchange designated for the trading of a specific option class. Each option traded at a particular post is managed by an assigned specialist. A specialist is an Exchange member whose function is to maintain a fair and orderly market in a given option class.
This is accomplished by managing the limit order book and making bids and offers for his own account in the absence of opposite market side orders, i. Other options exchanges have similar structures for trading options, whether electronic or on-floor. By law, standardized equity options traded in the United States may only occur on a national securities exchange registered with the SEC.