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Understanding Different Option Types for Investing

written by: Charles M Bowen•edited by: Jason C. Chavis•updated: 8/31/2011

There are various types of options available for trading in derivative securities. This article explains how the put and call options work and also what the difference between American, European and Asian types of options are.

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    Types of Options

    What is an Option?

    Options, like futures and forward contracts, are types of derivative contracts that allow you to buy/sell an asset at a future date. They are called derivatives because the value of the option is derived from an underlying asset. Different types of options give the buyer the right, but not the obligation to buy or sell the underlying asset at a predecided price on a future date. In contrast, a futures contract forces the buyer/seller to carry out the transaction on the future date at the specified price.

    The option buyer pays a premium (option price) in order to get that right to decide whether or not to conduct that transaction in the future. For more details on options, check out this article - Learn about Derivatives in Capital Markets.

    Based on how they are exercised, options can be divided into different types:

    1. European Options

    These are options that can be exercised only on the expiration date, not before it. They are generally based on indices.

    2. American Options

    These are options that can be exercised at any time before or on the expiration date. The holder of these options can use them whenever he sees fit, before the settlement date. They are generally used for individual stocks.

    3. Asian Options

    Asian options are a type of exotic options. In these, the payoff price is determined not by the spot price at the time of maturity, but by the average price over some period of time before expiry. They are used in highly complex derivatives.

    Terminology in Options Trading

    1. Option Price - This is the cost of the option which the option buyer pays to the option seller for the right to buy/sell the underlying asset at a future date

    2. Strike Price - This is the predecided price at which the option buyer can conduct the transaction on/before the expiry date.

    3. Spot Price - This is the price of the asset at the point when the transaction is actually done.

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    Call and Put options

    Besides these, there are two basic types of options.

    1. Call Option

    In this type of option, the option buyer gets the right but not the obligation to buy the underlying asset at a fixed price on the expiration date or before it (depending on whether it is a European or American option).

    For example, A buys a call option from B for $5 to buy stock X on 31/12/2010 for $100.

    Option Price = $5

    Strike Price = $100

    Spot Price = Price of Stock X on 31/12/2010

    Now if the price of stock X rises above $100, say $110, then the option buyer can exercise the option to buy the stock X at $100 and sell it at $110 to make a gross profit of $10.

    As he already paid $5 to buy the option, his net profit is $10 - $5 = $5.

    If the spot price of the stock X is $90, then he can simply choose to not exercise the option (as if he exercises the option, he loses $100 - $90 = $10).

    Thus the buyer of a call option profits if the spot price rises above the strike price on the day of expiration. If the spot price is below the strike price, his loss is limited to the option price.

    2. Put Option

    In this type of option, the option buyer gets the right but not the obligation to sell the underlying asset at a fixed price on the expiration date or before it (depending on whether it is a european or american option).

    For example, A buys a put option from B for $5 to buy stock X on 31/12/2010 for $100.

    Option Price = $5

    Strike Price = $100

    Spot Price = Price of Stock X on 31/12/2010 ($110)

    Now if the price of stock X falls below $100, say $90, then the option buyer can exercise the option to buy the stock X at $90 in the open market and sell it to the option seller at $100 to make a gross profit of $10.

    As he already paid $5 to buy the option, his net profit is $10 - $5 = $5.

    Thus the buyer of a put option profits if the spot price falls below the strike price on the day of expiration.

    If the spot price of the stock X is $110, then he can simply choose to not exercise the option (as if he exercises the option, he loses $110 - $100 = $10).

    Thus the buyer of a put option profits if the spot price falls below the strike price on the day of expiration. If the spot price is more than the strike price, his loss is limited to the option price.

References

  • "Types of Options" Investopedia: http://www.investopedia.com/university/options/option3.asp