Options
A standard trade involves a firm agreement to buy or sell something on a specified date. The buyer of a Treasury Bill has an obligation to deliver money to the seller on the agreed date. An options contract bestows the right, but not the obligation, on the buyer of a contract to transact at some future date. It is a two step process: first the right to trade is exchanged, then the actual exchange itself occurs.
Calls
A call option gives the buyer of the option the right to purchase some underlying asset at a specific price. For instance, let’s say EUR/USD is currently trading at 1.0915. Trader A believes that the price of EUR/USD will go up over the next month. He purchases a 1 month call option from Trader B at a strike price of 1.1000. The strike price is the price at which Trader A has the right to buy EUR/USD from Trader B in 1 month’s time. The expiry date is one month from today.
If the price of EUR/USD is above 1.1000 on the expiry date, trader A will be able to buy EUR/USD at a price lower than the current market value, sell it, and realize an immediate profit. To compensate against this risk, trader B charges a premium. The premium is the price of the option, and the greater the likelihood of EUR/USD rising above the strike price the higher the premium will be.
In the below diagram, the largest loss a call buyer (long) will ever realize is the premium paid. As the price of the asset increases (left to right) the call becomes more valuable. When the market price rises above the strike, the trader will begin to have some value in the option. At some point the difference between the current market price and the strike price will be greater than the premium paid, and the trader realizes a profit.
If the price of EUR/USD is above 1.1000 on the expiry date, trader A will be able to buy EUR/USD at a price lower than the current market value, sell it, and realize an immediate profit. To compensate against this risk, trader B charges a premium. The premium is the price of the option, and the greater the likelihood of EUR/USD rising above the strike price the higher the premium will be.
In the below diagram, the largest loss a call buyer (long) will ever realize is the premium paid. As the price of the asset increases (left to right) the call becomes more valuable. When the market price rises above the strike, the trader will begin to have some value in the option. At some point the difference between the current market price and the strike price will be greater than the premium paid, and the trader realizes a profit.
When selling a call (short) the highest profit a trader will ever realize is the premium received. When the market price of the security rises above the strike price, the short call begins to lose value. At a certain point the loss of value in the position will exceed the premium and the trader will suffer a loss.
Puts
The purchaser of a put option is buying the right to sell an underlying asset at some future date. He must still pay the seller of the option (or option writer) for this right. The greater the probability of the asset declining below the strike price before expiry the higher the premium.
In the below diagram, the largest loss a put buyer (long) experiences is the premium paid. As the price of the asset declines (right to left) the long put position becomes more valuable. Eventually the market price passes the breakeven point, where the difference from the strike price exceeds the premium, and the trader realizes a profit.
In the below diagram, the largest loss a put buyer (long) experiences is the premium paid. As the price of the asset declines (right to left) the long put position becomes more valuable. Eventually the market price passes the breakeven point, where the difference from the strike price exceeds the premium, and the trader realizes a profit.
The seller of a put contract (short) realizes a max profit of the premium received. As the market value of the security falls, so too does the value of the short put position. Eventually this loss of value exceeds the premium gained, and the trader experiences a loss.
American vs. European |
American style options can be exercised at any time up until and including the expiry date. Exercise is when the option buyer (or holder) chooses to exercise the right which he has purchased: buying the asset in the case of a call or selling the asset in the case of a put. European style options can only be exercised on the day of expiry, and not before.