Options

Definition

Options are financial derivatives that give an investor the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame. They can be used for hedging or speculation, allowing investors to manage risk and enhance potential returns while also providing flexibility in investment strategies.

5 Must Know Facts For Your Next Test

1. Options can be classified as either American or European, depending on when they can be exercised; American options can be exercised anytime before expiration, while European options can only be exercised at expiration.
2. Options trading involves paying a premium, which is the cost of acquiring the option, and this premium varies based on factors like the underlying asset's volatility and time until expiration.
3. Options can serve various purposes such as hedging against potential losses in an investment portfolio or speculating on market movements for potential profit.
4. The risk associated with options trading can be significant; while the maximum loss for buyers is limited to the premium paid, sellers of options can face unlimited risk if the market moves against them.
5. It's essential to understand terms such as 'in-the-money', 'at-the-money', and 'out-of-the-money' to assess an option's profitability potential based on the underlying asset's current market price.

Review Questions

• How do call and put options differ in their function and strategic use for investors?
  • Call options allow investors to profit from an increase in the price of an underlying asset, providing a way to buy it at a lower predetermined price. In contrast, put options allow investors to benefit from a decrease in the asset's price by selling it at a higher agreed-upon price. Both types of options can be strategically used for hedging risks or speculating on future price movements, showcasing their flexibility in various market conditions.
• Evaluate how changes in volatility can affect option premiums and investor decisions.
  • When market volatility increases, option premiums tend to rise because higher volatility raises the probability of significant price movements in the underlying asset. This can lead investors to decide to buy options as a hedge against potential losses or as a speculative investment for profit. Conversely, when volatility decreases, premiums may drop, making options less attractive and possibly leading investors to refrain from purchasing them until market conditions change.
• Analyze how understanding concepts like 'in-the-money' and 'out-of-the-money' enhances an investor's decision-making process regarding options trading.
  • Understanding whether an option is 'in-the-money', 'at-the-money', or 'out-of-the-money' is crucial for investors as it informs them about the likelihood of exercising their options profitably. For instance, if a call option is in-the-money, it means the market price is above the strike price, making it advantageous to exercise. Conversely, if it's out-of-the-money, exercising would not yield any profit. This knowledge allows investors to make informed decisions about when to enter or exit trades based on their assessment of future market movements.

Related terms

Call Option: A call option gives the holder the right to buy an underlying asset at a specified price before the option's expiration date.

Put Option: A put option provides the holder with the right to sell an underlying asset at a predetermined price before the option expires.

Strike Price: The strike price is the set price at which the holder of an option can buy (call) or sell (put) the underlying asset.