Options are of two types- calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyers the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
TYPES OF OPTIONS
The Options are classified into various types on the basis of various variables. The following are the various types of options.
- On the basis of the underlying asset:
On the basis of the underlying asset the option are divided in to two types:
Index options:
These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.
Stock options:
Stock Options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.
- On the basis of the market movements :
On the basis of the market movements the option are divided into two types. They are:
Call Option:
A call Option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. It is brought by an investor when he seems that the stock price moves upwards.
Put Option:
A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. It is bought by an investor when he seems that the stock price moves downwards.
3. On the basis of exercise of option:
On the basis of the exercise of the Option, the options are classified into two Categories.
American Option:
American options are options that can be exercised at any time up to the expiration date. Most exchange –traded options are American.
European Option:
European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.
FACTORS AFFECTING THE PRICE OF AN OPTION
The following are the various factors that affect the price of an option they are:
Stock Price:
The pay-off from a call option is an amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa.
Strike price:
In case of a call, as a strike price increases, the stock price has to make a larger upward move for the option to go in-the –money. Therefore, for a call, as the strike price increases option becomes less valuable and as strike price decreases, option become more valuable.
Time to expiration:
Both put and call American options become more valuable as a time to expiration increases.
Volatility:
The volatility of a stock price is measured of uncertain about future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. The value of both calls and puts therefore increases as volatility increase.
Risk- free interest rate:
The put option prices decline as the risk-free rate increases where as the price of call always increases as the risk-free interest rate increases.
Dividends:Dividends have the effect of reducing the stock price on the X- dividend rate. This has a negative effect on the value of call options and a positive effect on the value of put options
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