I recently posted the following market overview on Facebook.
The buyer of a call option expects the price of the underlying share to rise, causing the option premium to rise with it, so that he can recoup the premium paid along with some profit. The maximum amount he risks losing is the premium paid.
Intrinsic Value and “In The Money” Options
If the underlying share price is higher than a call option strike price, the option has intrinsic value. The option is said to be “in the money”. It has value because the option could be exercised to buy the share at the strike price, which is cheaper than the market price. The intrinsic value is the difference between the strike price and the market price.
For example consider a call option over US Steel Group shares with a strike price of $100. If the market price of US Steel shares was $105, the intrinsic value of the call option would be:
“market price” – “strike price” = $105 – $100 = $5.
The buyer of a put option expects the underlying share price to fall. Remember that the holder of a put option has the right but not the obligation to sell the underlying share at the strike price. That means that the intrinsic value of a put option increases as the underlying share price falls. If the market price is below the strike price, the option has intrinsic value, because the holder can exercise the option to sell his shares at the strike price, which would be higher than the market price.
The intrinsic value of a put option is simply the “strike price” less the “market price”. This is the opposite to a call option. Consider US Steel again. This time we’ll look at a $100 put option. If the market price of US steel were $105 the $100 put would have no intrinsic value. At expiry no rational person would sell their US Steel shares for $100 if they could get $105 on the market. On the other hand, if the market price fell to $95, the $100 put option would be worth “strike” – “market” = $100 – $95 = $5. The put holder would be able to sell the share to the put writer at the $100 strike price, $5 above the $95 market price. Alternatively he could sell that put option for $5 to someone else who might want to offload that stock.
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An option is an agreement to buy or sell an asset at a fixed price on or before a given future date. An option is thus a contract between a writer and a taker. The underlying asset is a share in a company traded in the stock market, but there are options over other types of assets (e.g. currency commodities and bonds).
An option is similar to an insurance policy. The writer (seller) of an option receives money – the premium – to take on the risk that the price of the underlying share finishes above or below a certain price on a specified future date. The taker (buyer) pays the premium to be assured of a fixed price for a transaction in that share on that future date.
All options have an expiry date and therefore perish with time.
There are two types of options: call options and put options. Options markets are use to speculate on price direction , hedge portfolios and forward purchase shares.
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