Options

Definition

First let’s start out by clarifying what options are. Options are contracts. The full name of options is actually “Options Contracts”, but for the sake of simplicity they are always referred to as simply “options”. Legally speaking an option is Contract for the right to buy (or sell) of X number of underlying asset, or security, at a specified time and at a specified price. The number of the underlying asset is usually a bundle of whole number, especially for options that are publicly traded at exchanges. For example, one option is a hundred shares. An option for the right to buy an option is called a “call option”, and an option for the right to sell and option is called a “put option”. Notice that the contract provides only a right, not an obligation. This means that if the current, price (called the “spot price”) in of the underlying asset or security is not proper, i.e., would cause a loss for the option holder, he/she may decide not to exercise the option, and his/her loss is only the price of the option, which is usually around 1-5% of the current price (at the time of opening the option) of the underlying asset or security. 

Example

An example for an option would be a monthly put option of Google shares at a $100. This means that the holder of this contract has the right, but not the obligation, to sell 100 Google shares at $100 each one month from the opening of the contract. If this put option was purchased, when the price of one Google share was $90, one month later, when the option is exercises, the holder can sell the Google shares included in the option at $100 each making a gross profit of $10,000 minus the option fee, which is somewhere between $100 and $500. Thus the net profit, before taxes, is $9,900-$9,500. This profit was made with an initial investment of $100-$500. If the option would have been bought at a leverage, which can be between 1:1 -1:100 times investment, this profit would have been much larger. Note that the Google share in the option can be sold at $100, even if the spot price of the stock is lower than the original $90. This profit in the example may look astounding, but the risk also has to be noted, namely if the spot price is at the time of the maturity is $110, if the option is exercised, there is a loss of $1000 (100 shares at $10 loss each). If the option is not called, then ALL of the option price is lost, that is, the loss is $100-$500. 

Types of Options

There are two kinds of options: American type of options and European type of options. The fact that they have geographical names, does not exclude to be traded at the other continent, in fact, they are often traded all over the world, or rather at the options exchange only, but the exchange itself can be located anywhere in the world.

So what are American options, European options, and how are they different and similar? The difference major difference between the two is their tradability before there maturity. American options can be sold, and purchased as well, anytime before maturity. European options can only be exercised at the time of maturity, and can never be traded (there are some special, and rare events when they can change ownership such as inheritance).

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