contract

An option is a contract between two parties. The buyer of an option purchases - on payment of the option price (premium) - the right

to buy

or to sell

a standardized quantity

of a certain financial instrument

at or before a date determined in advance

at a price determined in advance

(call option)

(put option)

(contract size)

(underlying asset)

(expiry date)

(strike price)

The option buyer acquires the right - but is not obliged - to exercise an option. In return for this, he pays the writter the option premium on conclusion of the contract.The rights to buy (call) or sell (put) are held by the person buying the option who is known as the holder. The person selling an option is known as a writer.

The price at which an options contract gives the right to buy (call) or sell (put) is known as the exercise price or strike price. When options holder wish to take up their rights under the contract they are said to exercise the contract.

For a call, the seller (option writer) is obliged to sell the underlying asset at the exercise price.
For a put, the seller (option writer) is obliged to buy the underlying asset at the exercise price.

Options are instruments with limited life spans. The date on which an option comes to the end of its life is known as its expiry date. The expiry date is the last day on which the option may be exercised or traded. After this date the option disappears and cannot be traded or exercised.

Options are available in a range of different exercise styles that are specified when the options are traded. There are two potential styles:

American style options: in which the holder can exercise the option at any time after the option has been purchased.
European style options: when the option can only be exercised on its expiry date.

The option buyer and the option seller have the opportunity to close their options contracts at any time by means of an offsetting transaction.

Components of option premium

The option price is constitued of 2 price components, the intrinsic value and the time value.

Option price = intrinsic value + time value

Intrinsic value: The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option.

The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option.

	Call	Put
Strike price < underlying security price	In-the-money Intrinsic value >0	Out-of-the-money Intrinsic value = 0
Strike price > underlying security price	Out-of-the-money Intrinsic value = 0	In-the-money Intrinsic value >0
Strike price = underlying security price	At-the-money Intrinsic value = 0	At-the-money Intrinsic value = 0

The time value: It is determined by the remaining lifespan of the option, the volatility and the cost of refinancing the underlying asset (interest rates).

Time value = option price - intrinsic value

Factors determining the premium

There are 6 factors which impact on the price of an option. These factors are:

Option exercise price

Current underlying price

Remaining lifespan of the option

Volatility

Interest rates

Dividend

The following correlations apply to stock options:

Factor rises / is higher	Price of call	Price of put
Option exercise price	lower	higher
Current underlying price	higher	lower
Remaining lifespan	higher	higher
Volatility	higher	higher
Interest rates	higher	lower
Dividend	lower	higher

Four basic options strategies

Purchase of a call option (long call)

Rights and liabilities	The buyer of a call, in exchange for payment of the premium, acquires the possibility of buying the underlying asset at the exercise price.
Market expectation	Market price up and implied volatility up.
Profit potential	Unlimited profit.
Loss potential	Limited loss to premium paid.

Purchase of a put option (long put)

Rights and liabilities	The buyer of a put, in exchange for payment of the premium, acquires the possibility of selling the underlying asset at the exercise price.
Market expectation	Market price down and implied volatility up.
Profit potential	Unlimited profit.
Loss potential	Limited loss to premium paid.

Sale of a call option (short call)

Rights and liabilities	The seller of a call is in the opposite direction to the buyer. He immediately receives the option premium, but he has the obligation to deliver the underlying asset if the buyer of the call exercises the option.
Market expectation	Market price down and implied volatility down.
Profit potential	Limited to premium received.
Loss potential	Unlimited.

Sale of a put option (short put)

Rights and liabilities	The seller of a put is in the opposite direction to the buyer. He immediately receives the option premium, but he has the obligation to receive the underlying asset if the buyer of the put exercises the option.
Market expectation	Market price up and implied volatility down.
Profit potential	Limited to premium received.
Loss potential	Limited to exercise price minus premium received.