What are the Financial Options?
A financial option also known as purchase option is a contract that gives its buyer the right, but not the obligation, to buy or sell assets or securities (the underlying asset, which can be shares, stock indices, etc.). A predetermined price (strike or exercise price) until a specified date (maturity).
The option pricing models were very simple and incomplete until 1973, when Fischer Black, Myron Scholes and Robert C. Published Merton pricing model Black-Scholes-Merton. In 1997 Scholes and Merton received the Nobel Prize in Economics for this work. Sadly, Fischer Black died in 1995, which is why he was not awarded but undoubtedly had been one of the winners. The Black-Scholes-Merton gives theoretical values for European put and call options on stocks that pay dividends. The key argument is that investors could, without running any risk, long positions with offsetting short positions of the action and continuously adjust the hedge ratio (delta value) if necessary. Assuming that the underlying price follows a random walk, and using stochastic methods of calculation, the option price can be calculated where there are no arbitrage possibilities. This price depends only on five factors: the current price of the underlying, the exercise price, the interest rate risk-free, time to exercise date and the volatility of the underlying. Finally, the model was also adapted to be able to value options on stocks that pay dividends.
The availability of a good estimate of the theoretical value contributed to the explosion of options trading. They have developed other option pricing models for other markets and situations using arguments, assumptions and similar tools, such as the Black model for options on futures, the Monte Carlo method or the binomial model.
A call option gives its buyer the right, but not the obligation, to buy an underlying asset at a predetermined price on a specific date. The seller of the call option has the obligation to sell the asset if the buyer exercises the right to buy.
A put option gives its holder the right, but not the obligation, to sell an asset at a predetermined price until a specific date. The seller of the put option has the obligation to buy the asset if the option holder decides to exercise the right to sell the asset.
The option prime
It is the price the buyer of an option (put or call) pays the seller, in exchange for the right (to buy or sell the underlying predefined conditions, respectively) derived from the option contract. In return for the premium, the seller of a put option is obligated to purchase the asset if the buyer exercises the option. Symmetrically, the buyer of a put would be entitled (if they exercise the option) to sell the underlying conditions stipulated. In the case of a call, the buyer is entitled to purchase the underlying against payment of a premium, and vice versa for the seller to call. The seller of the option is always premium charged, regardless of who exercises the option. The premium of an option is negotiated according to the law of supply and demand set the market. However, there are theoretical models which attempt to determine the price of the option depending on a number of parameters:
- -Price of the underlying asset.
- -Exercise price.
- -Interest rate.
- -Dividends paid (only for options based in shares).
- -Time to maturity (the time of contract finalization).
- -Future Volatility of the instrument.
Types of financial options
- European options: These options can be exercised only at the expiration day of the contract.
- American options: These options can be exercised at any time between the date of purchase and the date when the contract expires, inclusive, and regardless of the market in which the contract was negotiated.
The most common options are European and American options, which are known as “plain vanilla”. Other more complex options are called “exotic”, and within these options we can find among others: Bermuda, binary options (also known as digital options), power, barrier, etc. The binary options are a very popular type of option among the investors because are very easy to understand and to trade with them, for these reasons, a lot of Forex brokers and other specialized brokers offer binary options among their trading instruments. Through this link, you can have access to a more detailed explanation of the binary options as a trading instrument and to a list of the most important brokers that trade with them:
As mentioned before, binary options are a type of exotic option, however there are many types of exotic options which are becoming increasingly popular among the investors. If you want to learn more about exotic options you can refer to the following link:
So basically we can say that all the different types of financial options fall into two main groups or categories:
- Bermuda options:This kind of options can only be exercised at certain times between the date of purchase and the finalization of the contract. That means that can be exercised only on particular days.
- Plain Vanilla Options: With these options, the trader can make the four elementary operations for options, for example buy Call Options, sell Call Options, buy Put Options and sell Put Options.