Derivatives: Options, Futures, Others

An Easy Derivatives Tutorial

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An "option" gives the holder the right to buy/sell an asset at a particular price some time in the future. Options have an expiry date.

A "call" option is the right to buy the asset. A "put" option is the right to sell the asset.

American options are options that may be exercised at any time up to the expiry date. European options may oly be exercised ON the expiry date.

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At any time an option may be:

In the money - the exercise price is favorable compared to the market price (ie less than market price for a call option and greater than market price for a put option)

Out of the money - the exercise price is less favorable than the market price (ie greater than market price for a call option and less than market price for a put option)

At the money - the exercise price EQUALS the market price

Traded options are traded through recognized exchanges. These offer the benefit of protecting traders from potential credit risks of counterparties and also providing liquidity, ie a ready supply of buyers and sellers.

"Over the counter" options are specifically agreed between buyer and seller. They may not be easy/possible to sell on, and carry the risk that the writer may not fulfill his/her obligations.

Writing Options

Writing options carries significantly more risk than buying them. The worst case for a buyer is that the option expires worthless, in which case he loses his entire stake. However, as the underlying asset may theoretically become worthless, or rise by an unlimited amount, the option writer could lose many times the price (premium) received for the option.

A naked call is one in which the writer does not on the underlying asset, so in the event of the option being exercised s/he would need to buy the asset at market price before selling it.

The writer of a put could potentially have to buy a now worthless asset at strike price.

Option Pricing

The price of a traded option is determined by supply and demand and influenced by:

  • the price of the underlying asset;
  • the time to expiry;
  • the type of option (American options are always at least as valuable as European options);
  • volatility.

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