Option Essay

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In the finance world, an option is a contract  between two parties when one party grants the other the right to buy/purchase  a specific asset at a particular  price within a particular time period. Alternatively, the contract  may grant the other party the right to sell a specific asset at a particular price within a particular time period. The party who has received the right but has no obligation and instead has the right of decision to make (buy/sell in the case of a call or put option) is known as an option  buyer or option  holder.  The party who has sold the right and is under the obligation to respond  to the buyer’s decision is known as the option writer or option issuer. The price at which options are exercised is known as the strike price or exercise price. The option buyer pays an option price to  the  option  seller known  as an option  premium. An option premium  is not refundable even when an option is not exercised. Options can take many forms, such as the following:

  • Call Option: A call option gives the option buyer the right to buy a specific asset on a specific date for a specific price. The option seller is under an obligation to fulfill the contract, that is, to sell, and he/she is paid for an option premium by the option  buyer. A call option  can be long call or short  call. A long call is when the trader  who believes that the stock price will increase might buy the call option rather than buy the stock. If the stock price increases over the exercise price of the  call option  by more  than  the  premium paid, he/she will get a profit. On the contrary, if the stock price decreases, he/she will not use the call option  and buy the stock from the market and lose the amount  of premium.  A short  call is when the trader  who believes that  the stock price  will decrease  might  short  sell the  stock instead of selling a call option.
  • Put Option: A put option gives its holder, that is, the option buyer, the privilege or right to sell a specific asset by a specific date for a specific price. The option seller is under an obligation to fulfill the contract,  that is, to buy, if the option buyer is ready to sell. The option writer charges the option  premium  initially for the same. The put option can be long put or short put. A long put is when the trader who hopes that the stock price  will decrease  can buy the  put  option.  If the  stock  price  decreases  below  the  exercise price by more  than  the  option  premium  paid, then  the trader  would get a profit. If the stock price increases, he/she will not exercise the put option and lose the option premium  being paid by him/her.  A short put is when the trader who hopes that the stock price will increase can buy the  stock  instead  of buying the  put  option.  If the stock price increases, a short put would give him/her  profit, and vice versa.
  • American Option: An option, either call or put, that can be exercised even before maturity/expiration date is called an American option.
  • European Option: An option, either call or put, that can be exercised only on the maturity/expiration date is called a European option.
  • Bermuda Option:  An option  that  can be exercised only on few specific dates prior to maturity is known as a Bermuda option.
  • Preference Option:  In  this  option,  the  option buyer gets a privilege to  designate  the  option either as a call option or put option.
  • Average Rate Option: This is the arithmetic average of the spot rate during the life of the option. It is the rate  that  is considered  at the  time  of maturity  instead of the spot rate. This rate can be applied to call as well as put options.
  • Compound Option:  This is the  option  on  an option. It can be a call on a call or a call on a put or a put on a put or a put on a call.

An option is a derivative instrument that is used to hedge risk. Both the option buyer and option writer can protect  themselves from an uncertain  situation. Hedging is being done by resorting to the purchase or sale of options. Speculators use options for speculative purposes. Normally, the speculator enters into vertical spread on call combinations, horizontal spread on call combinations,  or diagonal spread on call combinations, or straddles and strangles. Basically, there are three situations in option exercises. The first is at-the-money: this is the situation  in which the strike price is equal to the spot rate on the expiration  date. The second is in-the-money: in the case of a call option, an  in-the-money situation  is confronted  when  the strike price is lower than the spot price. Conversely, in the case of a put option, an in-the-money situation occurs when the spot price is lower than  the strike price. The third  situation  is out-of-the-money:  this is the opposite of the in-the-money situation. In the case of a call option,  an out-of-the-money situation is confronted  when the spot price is lower than  the strike price. Conversely, in the case of a put option, an out-of-the-money situation occurs when the strike price is lower than the spot price.

Option prices depend on a number of factors such as degree of volatility, interest  rate differential, expiration  date, change in forward  rate, change in spot price, and so forth. It is said that an option is “a double-edged sword to hedge against risk.”

Bibliography:

  1. Roger C. Charke, Options and Futures: A Tutorial (Research  Foundation  of the  Institute  of Chartered  Financial  Analysts, 1992);
  2. John C. Cox and Mark Rubenstein,   Options   Markets   (Pearson   Prentice   Hall, 1985);
  3. David A. Dubosky, Options and Financial Futures: Valuation & Uses (McGraw-Hill, 1992);
  4. Peter H. Ritchken, Options: Theory, Strategy, and Applications (Scott, Foresman, HarperCollins  1988);
  5. Vyuptakesh Sharan,  International Financial Management  (Prentice  Hall, 2001);
  6. Hans R. Stoll and Robert E. Whaley, Futures & Options: Theory & Applications (Southwestern, 1993).

This example Option Essay is published for educational and informational purposes only. If you need a custom essay or research paper on this topic please use our writing services. EssayEmpire.com offers reliable custom essay writing services that can help you to receive high grades and impress your professors with the quality of each essay or research paper you hand in.

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