Options Pricing

An option is a financial contract that gives the holder the right but not the obligation to buy and sell it at a predetermined price. In other words the holder of contract can sell it or keep it at his will, when the expiry date commences, as he is not obligated to do so.

 

A basic option contract consists of a strike price or the price at which the option is going to be traded, at a certain date and premium, or the price at which the buyer purchases the option. If for example a person wants to buy an option for 200 shares in ABC enterprises, he will have to pay a price or premium to purchase that contract say $10. Then if the share is trading at $10 per and the strike price is $12 per share he will have two options-

 

a) CALL OPTION

B) PUT OPTION

 

In a call option the person will buy the share during the expiry date. In the above example the person will assume that the price of the share will rise up more than $12 to say $14.If that happens, during the expiry date the person can purchase $14 dollar worth of shares for $12 thus making a profit(commission, fees and taxes not included ) of $390 or 14*200-[12*200+10].

 

In a put option the person will sell the shares during the expiry date. Again,

in the above illustration, the person will assume that the stock price will decrease below $12 to say $9 so when the contract expires he will sell $9 worth of shares for $12 and so, not including commission and taxes, his profit will be 12*200-[9*200+10] or $590.

 

Call options and put options are a great way to leverage shares and minimize the loss as the person will only lose the price that he paid for acquiring the options contract, which is only a tiny portion of the actual price money one would pay to buy that many number of shares. This is just a basic level intro as option trading is way more complicated and complex compared to this.

 

Options , whether call or put, can themselves be classified into 2 categories based on the underlying  stock ownership, Naked and covered. Naked options is writing or selling the option on stocks that is not owned by the seller and due to this reason they are highly volatile and very risky.

In a fictional scenario I want to sell a call option for 100 shares to my friend, on shares of a blue chip company that I do not own. If the shares are currently trading at $10, I sell the option for a premium of $150, at a $12 strike price, assuming that the stock price will not rise, more than $12. In this case 2 things can happen, my assumptions will be correct and I have made $150 dollars as a premium or the company is taken over by a powerful corporation and the share price has risen to $30 or in short I am at a loss.

 

This is because I will now have to buy 100 shares at $30 and sell them to my friend for $12 thus incurring a loss of $1200-$3000 or $1800.

But if, in this same scenario, I had actually owned the stock when selling the option then I would sell it for $12 without spending $3000 to buy the shares as I already own them.

 

So in a nutshell, this means that naked option trading must be only done by the most experienced traders who can afford to lose a lot of money and covered call trading must be done by the newest and least experienced people to prevent lot of losses.

 

Note- The above scenes take place without including fees, commission and taxes.

YFS is owner and author of Your Finances Simplified. He was born and raised in West Philadelphia and is now a financial adviser, IT contractor, landlord, and treasurer of a non-profit. He created his blog partly due to his desire to help people with their finances. Join YFS’s mailing list for straight forward financial advice by clicking here.

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