Mac intends to sell 100 kg of apples at a future date but he does not want to be adversely affected by adverse price movements.
The apples are being traded at $10/100 kg.
What does he do? Case1: He expects the price to rise and become $13.
He goes to Sam and buys an option contract that is an option to buy apples at future specified date at $10.
Mac pays an upfront price of $1 for the contract.
According to the contract he has got the option,not an obligation,to buy apples at the future specified date.
If he wants he can forgo the contract to buy apples from Sam.
Suppose the price of apples become $13 on expiry date.
Mac exercises his options i.
e.
he buys apples at 10 dollars from Sam.
He has paid a price of $1 so the total price becomes $11.
Case 2: Mac gives an option to John to buy apples at $11 at $1 price.
Mac expects the price of apples not to go beyond $12 (considering $1 he paid for the contract).
Suppose the price is $11,John would not exercise the option(as he can get the apples at same price from the market) and Mac makes a gain of $1(price of contract).
He can now buy apples from the market at $11 and thus his net price on the transaction is $10 (price of apples-gain from the contract).
The downside of the second case is that his liability is unlimited as the option of the contract rests with John.
And if the price goes beyond $12 he would have to buy the apples from the market and deliver them to John.
Suppose the price becomes $15.
He will receive $10 from John (the agreed upon price) and $1 as contractual price,which he received upfront.
So the loss would be $15-(10+1) =$14.
Understanding the terminology in the above examples.
Underlying.
That which is to be sold or bought at the expiration date.
In this case,it is apples.
Strike price.
The price at which the underling had been agreed to be bought or sold.
In the first case it is $12 and the second case it is $11.
Premium.
Premium is the price of the contract which is taken upfront.
In the above cases it is $1.
Expiration Date.
Date on which the option contract expires.
In the case of Stock options,in the US,it is the last Friday of the month.
Parties to an option contract Option holder.
The person who holds the option is called option holder.
In the first case Mac is the option holder Option writer.
The person who gives the option or writes the option is the option writer.
In the second case Mac is the option writer.
Types of option Call option: The option to buy underlying at a future specified date.
The first case is the example Put option: The option to sell the underlying at a future specified date is put option.
Second case is the example.
Stock options The option contracts where the underlying is stock are called stock options.
Stock options are structured contract listed on option exchange.
The seller of call/put option is the option writer the buyer of call or put option is the option holder.
The duration is generally 1 month,2 months,and 3 months and the expiry date is last Friday of the month(US).
Analyzing the quotes of options.
Market Price of X stock=$38 Call quoteXPut Quote 2May42 1 3May37 1 5May35 2.
5 Take the first row $2 is the call price (premium) May represents the May series (the expiry being the last Friday of the month in US) $42 is the strike price $1 is the put price (premium) Similarly,second row shows the May series of strike price $37 and the third row shows May series for strike price $35.
The apples are being traded at $10/100 kg.
What does he do? Case1: He expects the price to rise and become $13.
He goes to Sam and buys an option contract that is an option to buy apples at future specified date at $10.
Mac pays an upfront price of $1 for the contract.
According to the contract he has got the option,not an obligation,to buy apples at the future specified date.
If he wants he can forgo the contract to buy apples from Sam.
Suppose the price of apples become $13 on expiry date.
Mac exercises his options i.
e.
he buys apples at 10 dollars from Sam.
He has paid a price of $1 so the total price becomes $11.
Case 2: Mac gives an option to John to buy apples at $11 at $1 price.
Mac expects the price of apples not to go beyond $12 (considering $1 he paid for the contract).
Suppose the price is $11,John would not exercise the option(as he can get the apples at same price from the market) and Mac makes a gain of $1(price of contract).
He can now buy apples from the market at $11 and thus his net price on the transaction is $10 (price of apples-gain from the contract).
The downside of the second case is that his liability is unlimited as the option of the contract rests with John.
And if the price goes beyond $12 he would have to buy the apples from the market and deliver them to John.
Suppose the price becomes $15.
He will receive $10 from John (the agreed upon price) and $1 as contractual price,which he received upfront.
So the loss would be $15-(10+1) =$14.
Understanding the terminology in the above examples.
Underlying.
That which is to be sold or bought at the expiration date.
In this case,it is apples.
Strike price.
The price at which the underling had been agreed to be bought or sold.
In the first case it is $12 and the second case it is $11.
Premium.
Premium is the price of the contract which is taken upfront.
In the above cases it is $1.
Expiration Date.
Date on which the option contract expires.
In the case of Stock options,in the US,it is the last Friday of the month.
Parties to an option contract Option holder.
The person who holds the option is called option holder.
In the first case Mac is the option holder Option writer.
The person who gives the option or writes the option is the option writer.
In the second case Mac is the option writer.
Types of option Call option: The option to buy underlying at a future specified date.
The first case is the example Put option: The option to sell the underlying at a future specified date is put option.
Second case is the example.
Stock options The option contracts where the underlying is stock are called stock options.
Stock options are structured contract listed on option exchange.
The seller of call/put option is the option writer the buyer of call or put option is the option holder.
The duration is generally 1 month,2 months,and 3 months and the expiry date is last Friday of the month(US).
Analyzing the quotes of options.
Market Price of X stock=$38 Call quoteXPut Quote 2May42 1 3May37 1 5May35 2.
5 Take the first row $2 is the call price (premium) May represents the May series (the expiry being the last Friday of the month in US) $42 is the strike price $1 is the put price (premium) Similarly,second row shows the May series of strike price $37 and the third row shows May series for strike price $35.
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