How Options are Priced?
The options are priced based on a ‘premium’ amount. This ‘premium’ amount is calculated based on intrinsic and time value. Intrinsic value depicts the difference between the strike price and the spot price (the current price of the underlying asset). Whereas time value depicts factors such as time remaining until expiration, interest rates, and market volatility calculated in addition to the intrinsic value. Time value is also termed as the Extrinsic value of the option contract.
What are Options and How it Works?
Options, in the derivative market, are a type of financial instrument that helps to purchase high-valued underlying assets at a comparatively lower price, potentially generating considerable profits. The underlying assets refer to stocks, indexes, exchange-traded funds (ETFs), or commodities. The options are contracts bought and sold by the ‘buyer’ based on the type of contract, i.e., the underlying asset. These contracts have a particular expiration date within which the holder of the contract must exercise their option. In options trading, the buyer is called the ‘holder’ of the contract. The mentioned price of an option is termed the strike price or the exercise price. The options are usually bought and sold via retail or online brokers. In addition to this, options contracts are not obligated to exercise the contract, unlike other derivative products (forwards or futures).
Geeky Takeaways:
- Definition: Options are a type of derivative contract that provides the ‘holder’ the right to buy or sell, but not the obligation, an underlying asset or a financial instrument at an agreed-upon exercise price on or before a specified date based on the type of option (index, stock, commodities or ETFs).
- History: Initially, options were used for olive harvest speculation in ancient Greece. Current options (used for investment) were first published in the Chicago Exchange. Later in 1973, the European Options Exchange was formed in Amsterdam.
- Types: Basically, there are two types – call and put options, which form the basis for a broad range of option strategies developed for generating income, hedging, or speculating.
- Benefit: Options have multiple opportunities to earn profit, but by carefully weighing their risks. It is a complicated derivative product that provides multiple advantages compared to stocks or ETFs.
Table of Content
- How does Options Work?
- Features of an Option Contract
- How Options are Priced?
- Types of Options
- Options Risk Metrics
- Advantages of Options
- Disadvantages of Options
- How do Options Differ from Futures?
- How to Use Options in Trading?
- FAQs