OPTIONS: TRADING ON FUTURES, STOCKS, BONDS, CURRENCIES AND COMMODITIES
Options are often considered unilateral contracts because these contracts confer the right but not the obligation to exercise to the owner. The owner is also known as the holder, purchaser or long the option. The purchaser of an option pays a premium which grants the buyer the right to exercise the claim on the underlying market. This right is limited to time (known expiration date), strike price or exercise level, can be exercised at any time (American Style) or only on the final or termination date (European Style).
It should be noted that long the option is not necessarily synomous with long the market. This is so because a long put indicates a position with negative or bearish market attributes.
There are only two types of options: calls and puts. However, there is a variety of calls and puts and associated strategies.
Call options grant the purchaser the right to exercise into the underlying instrument or market. Generally, calls on an individual stock enable the purchaser to "buy" the stock at a set strike price within the stipulated time frame. Assuming an investor exercised a call on IBM then, that investor would acquire 100 shares of IBM at the agreed strike price. The seller of the call at that time would be either short the stock or would transfer ownership of 100 shares of a previously existing long IBM position. This exercise against a short option position is called an assignment. If the option expired unexercised, then it is referred to as abandoned.
A few common varieties of options are: European, American, and Asian.
Some exotic options are: Bermuda, Lookback, Knockin, Knockout, and Binary.
Options are used for risk management, investing, and speculative purposes. Important institutional users are: banks, brokers, dealers, B/Ds, mutual funds, investment companies, insurers, producers, and other organizations which have financial interests and exposures.
Options are also used by some individuals for hedging portfolios or for speculative purposes. There are various issues relating to suitability for options.
Options are available for many products and derivatives. Among these are: stocks, commodities, real estate, Mortgage Backed Securities, Indices, Baskets of Securities, Currencies (forex, Euro), bonds and other credit instruments, futures, and even other options. Here, an option-on-an-option is called a compound option.
Options are flexible trading and risk management tools. Because of the leverage involved a relatively small amount of capital can (temporarily) control a substantially larger economic trading position.
There are many options pricing models. A brief listing includes: Black, Black-Scholes, Binomial, and CIR. Different models may take into account different probability functions, dividends (yes or no), continuous or discrete times, stochastics, and so on. However, it should be remembered that whatever the model chosen and the level of complexity all these models should produce the same result at the end or expiry. If not, then there is a bias which may be exploitable in an arbitrage sense. As you move away from expiration, then the models tend to indicate different valuations for in, at, and out-of-the-money strikes.
Finally, it should be noted that options models as well as other financial evaluation packages and software should come with a warning. The warning should read: Using this software with blind reliance on its assumptions can cause financial damage.
For more information, this online site contains many references for Options and other Derivatives. The following list highlights some of these references.
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