More sophisticated models are used to model the volatility smile. Options are part of a larger class of financial instruments known as derivative products , or simply, derivatives. FLEX and LEAPS options offer investors increased flexibility in terms of contract customization such as expiration date, exercise style, and exercise price and time frame with expirations of up to three years out. For additional information on equity options, visit the Equity Option Strategies section of the web site. The Tradeoff Theory of Leverage
What is an 'Exchange-Traded Option' An exchanged-traded option is a standardized contract to either buy (using a call option) or sell (using a put option) a set quantity of a specific financial product (the underlying asset), on or before a pre-determined date (the expiration date) for a .
The standardization of exchange-traded options also enables clearing houses to guarantee that options contract buyers will be able to exercise their options — and that options contract sellers will fulfill the obligations they take on when selling options contracts — because the clearing house can match any of a number of options contract buyers with any of a number of options contract sellers. Clearing houses can do this more easily because the terms of the contracts are all the same, making them interchangeable.
Exchange-traded options do have one significant drawback: However, in most cases traders will find exchange-traded options provide a wide enough variety of strike prices and expiration dates to meet their trading needs.
What is an 'Exchange-Traded Option' An exchanged-traded option is a standardized contract to either buy using a call option or sell using a put option a set quantity of a specific financial product the underlying asset , on or before a pre-determined date the expiration date for a pre-determined price the strike price.
An option agreement is a legal contract between two parties outlining An underlying option security is the financial instrument stock, Options are part of a larger class of financial instruments known as derivative products , or simply, derivatives. A financial option is a contract between two counterparties with the terms of the option specified in a term sheet.
Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications: Exchange-traded options also called "listed options" are a class of exchange-traded derivatives. Exchange-traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the Options Clearing Corporation OCC.
Since the contracts are standardized, accurate pricing models are often available. Over-the-counter options OTC options, also called "dealer options" are traded between two private parties, and are not listed on an exchange.
The terms of an OTC option are unrestricted and may be individually tailored to meet any business need.
In general, the option writer is a well-capitalized institution in order to prevent the credit risk. Option types commonly traded over the counter include:. By avoiding an exchange, users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition, OTC option transactions generally do not need to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must establish credit lines with each other, and conform to each other's clearing and settlement procedures.
With few exceptions,  there are no secondary markets for employee stock options. These must either be exercised by the original grantee or allowed to expire. The most common way to trade options is via standardized options contracts that are listed by various futures and options exchanges.
By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute transactions.
As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include:. These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. An option contract in US markets usually represents shares of the underlying security. A trader who expects a stock's price to increase can buy a call option to purchase the stock at a fixed price " strike price " at a later date, rather than purchase the stock outright.
The cash outlay on the option is the premium. The trader would have no obligation to buy the stock, but only has the right to do so at or before the expiration date. The risk of loss would be limited to the premium paid, unlike the possible loss had the stock been bought outright.
The holder of an American-style call option can sell his option holding at any time until the expiration date, and would consider doing so when the stock's spot price is above the exercise price, especially if he expects the price of the option to drop.
By selling the option early in that situation, the trader can realise an immediate profit. Alternatively, he can exercise the option — for example, if there is no secondary market for the options — and then sell the stock, realising a profit. A trader would make a profit if the spot price of the shares rises by more than the premium. For example, if the exercise price is and premium paid is 10, then if the spot price of rises to only the transaction is break-even; an increase in stock price above produces a profit.
If the stock price at expiration is lower than the exercise price, the holder of the options at that time will let the call contract expire and only lose the premium or the price paid on transfer.
A trader who expects a stock's price to decrease can buy a put option to sell the stock at a fixed price "strike price" at a later date.
The trader will be under no obligation to sell the stock, but only has the right to do so at or before the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will make a profit. If the stock price at expiration is above the exercise price, he will let the put contract expire and only lose the premium paid. In the transaction, the premium also plays a major role as it enhances the break-even point.
For example, if exercise price is , premium paid is 10, then a spot price of to 90 is not profitable. He would make a profit if the spot price is below It is important to note that one who exercises a put option, does not necessarily need to own the underlying asset. Specifically, one does not need to own the underlying stock in order to sell it. The reason for this is that one can short sell that underlying stock. A trader who expects a stock's price to decrease can sell the stock short or instead sell, or "write", a call.
The trader selling a call has an obligation to sell the stock to the call buyer at a fixed price "strike price". If the seller does not own the stock when the option is exercised, he is obligated to purchase the stock from the market at the then market price. If the stock price decreases, the seller of the call call writer will make a profit in the amount of the premium. If the stock price increases over the strike price by more than the amount of the premium, the seller will lose money, with the potential loss being unlimited.
A trader who expects a stock's price to increase can buy the stock or instead sell, or "write", a put. The trader selling a put has an obligation to buy the stock from the put buyer at a fixed price "strike price". If the stock price at expiration is above the strike price, the seller of the put put writer will make a profit in the amount of the premium.
If the stock price at expiration is below the strike price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the strike price minus the premium.
Combining any of the four basic kinds of option trades possibly with different exercise prices and maturities and the two basic kinds of stock trades long and short allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several. Strategies are often used to engineer a particular risk profile to movements in the underlying security. For example, buying a butterfly spread long one X1 call, short two X2 calls, and long one X3 call allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss.
Selling a straddle selling both a put and a call at the same exercise price would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss.
Similar to the straddle is the strangle which is also constructed by a call and a put, but whose strikes are different, reducing the net debit of the trade, but also reducing the risk of loss in the trade. Priority Of Transaction 1.
Composites And Verification 1. Disclosure And Scope 1. Requirements And Recommendations 1. Fundamentals Of Compliance And Conclusion 2. Pegged Exchange Rate Systems 5. Revenue Recognition Principles 6. Revenue Recognition Special Cases 6. Earnings Per Share 6. Components and Format of the Balance Sheet 6. Measurement Bases of Assets and Liabilities 6. Balance Sheet Ratios 6.
Cash Flow Measures 6. Cash Flow from Operations 6. Cash Flow Statement Analysis 6. Cash Flow from Investing and Financing 6. Financial Analysis Tools and Techniques 6. Activity, Operational and Liquidity Ratios 6. Return on Equity 6. Fixed Income Investments The Tradeoff Theory of Leverage The Business Cycle The Industry Life Cycle Intramarket Sector Spreads Calls and Puts American Options and Moneyness Long and Short Call and Put Positions Covered Calls and Protective Puts.
Over the Counter Options Many derivative instruments such as forwards, swaps and most exotic derivatives are traded OTC. OTC Options are essentially unregulated Act like the forward market described earlier Dealers offer to take either a long or short position in option and then hedge that risk with transactions in other options derivatives.
Buyer faces credit risk because there is no clearing house and no guarantee that the seller will perform Buyers need to assess sellers' credit risk and may need collateral to reduce that risk. Price, exercise price, time to expiration, identification of the underlying, settlement or delivery terms, size of contract, etc.
Exchange-Traded Options An option traded on a regulated exchange where the terms of each option are standardized by the exchange.
Related Equity Option Information
tory understanding of equity options and how they can be used. Options are also traded on a wide variety of indexes, on U.S. Treasury rates, and on foreign currencies; information on these option products is not included in this booklet but can be obtained by contacting your broker or the exchanges on which these options are listed. Exchange traded equity options are "physical delivery" options. This means that there is a physical delivery of the underlying stock to or from your brokerage account if the option is exercised. The owner of an equity option can exercise the contract at any time prior to . Equity options, which are the most common type of equity derivative, give an investor the right but not the obligation to buy a call or sell a put at a set strike price prior to the contract’s expiry date.