Options belong to the larger group of securities known as derivatives. A derivative's price is dependent on or derived from the price of something else. As an example, wine is a derivative of grapes ketchup is a derivative of tomatoes, and a stock option is a derivative of a stock. Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities, among others.
There are also exotic options, which are exotic because there might be a variation on the payoff profiles from the plain vanilla options. Or they can become totally different products all together with "optionality" embedded in them. For example, binary options have a simple payoff structure that is determined if the payoff event happens regardless of the degree. Other types of exotic options include knock-out, knock-in, barrier options, lookback options, Asian options, and Bermudan options. Again, exotic options are typically for professional derivatives traders.
In Economics, a commodity is a marketable item produced to satisfy wants or needs. The commodity is generally Fungible (Fungibility is the property of a good or commodity whose individual units are capable of being substituted in place of one another). For example, since one ounce of pure gold is equivalent to any other ounce of pure gold, gold is fungible. Other fungible goods are Crude oil, steel, iron ore, currencies, precious metals, alloy and non-alloy metals.
For example: A trader in October 2016 agrees to deliver 10 tons of steel for INR 30,000 per ton in January 2017 which is currently trading at INR 29,000 per ton. In this case, trade is assured because he got a buyer at an acceptable price and a buyer because knowing the cost of steel in advance reduces uncertainty in planning. In this case, if the actual price in January 2017 is INR 35,000 per ton, the buyer would be benefitted by INR 5,000 (INR 35000-INR 30,000). On the other hand, if the price of steel becomes INR 26,000 per ton then the trader would be benefitted by INR 4,000 (INR 30,000- INR 26000)
Similarly, if you believe the company’s share price is going to dip to $80, you’d buy a put option (giving you the right to sell shares) with a strike price above $80 (ideally a strike price no lower than $80 plus the cost of the option, so that the option remains profitable at $80). If the stock drops below the strike price, your option is in the money.
Remember, a stock option contract is the option to buy 100 shares; that’s why you must multiply the contract by 100 to get the total price. The strike price of INR 300 means that the stock price must rise above INR 300 before the call option is worth anything; furthermore, because the contract is INR 10 per share, the break-even price would be INR 310(INR 300 + INR 10).
Options trading may seem overwhelming, but they're easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.
For example, if you bought a long call option (remember, a call option is a contract that gives you the right to buy shares later on) for 100 shares of Microsoft stock at $110 per share for December 1, you would have the right to buy 100 shares of that stock at $110 per share regardless of if the stock price changed or not by December 1. For this long call option, you would be expecting the price of Microsoft to increase, thereby letting you reap the profits when you are able to buy it at a cheaper cost than its market value. However, if you decide not to exercise that right to buy the shares, you would only be losing the premium you paid for the option since you aren't obligated to buy any shares.
If there’s a company you’ve had your eye on and you believe the stock price is going to rise, a “call” option gives you the right to purchase shares at a specified price at a later date. If your prediction pans out you get to buy the stock for less than it’s selling for on the open market. If it doesn’t, your financial losses are limited to the price of the contract.
A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one. Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a calendar spread or time spread.
With options markets, as with futures markets, long and short refer to the buying and selling of one or more contracts, but unlike futures markets, they do not refer to the direction of the trade. For example, if a futures trade is entered by buying a contract, the trade is a long trade, and the trader wants the price to go up, but with options, a trade can be entered by buying a Put contract, and is still a long trade, even though the trader wants the price to go down. The following chart may help explain this further:
The price you pay for an option, called the premium, has two components: intrinsic value and time value. Intrinsic value is the difference between the strike price and the share price, if the stock price is above the strike. Time value is whatever is left, and factors in how volatile the stock is, the time to expiration and interest rates, among other elements. For example, suppose you have a $100 call option while the stock costs $110. Let’s assume the option’s premium is $15. The intrinsic value is $10 ($110 minus $100), while time value is $5.
A sampling of terms defined includes: active premium, aggregation, angel financing, asset allocation, backwardation, benchmark, bridge loan, capital structure arbitrage, coefficient of determination, commodity option, convertible arbitrage, deferred futures, discretionary trading, distressed debt, enumerated agricultural commodities, extrinsic value, follow-on funding, hedge ratio, interdelivery spread, long short equity, modified value-at-risk, offshore fund, piggyback registration, social entrepreneurship, systematic trading, tracking error, underlying futures contract, venture capital method, and weather premium.
As an example, let's say a farmer is expecting to produce 1,000,000 bushels of soybeans in the next 12 months. Typically, soybean futures contracts include the quantity of 5,000 bushels. The farmer's break-even point on a bushel of soybeans is $10 per bushel meaning $10 is the minimum price needed to cover the costs of producing the soybeans. The farmer sees that a one-year futures contract for soybeans is currently priced at $15 per bushel.
American options can be exercised at any time between the date of purchase and the expiration date. European options are different from American options in that they can only be exercised at the end of their lives on their expiration date. The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.
The currency market, or foreign exchange market ("forex"), was created to facilitate the exchange of currency that becomes necessary as the result of foreign trade. That is, when an entity in one country sells something to an entity in another country, the seller earns that foreign currency. When China sells t-shirts to Walmart, for example, China earns US dollars. When Toyota wants to build a factory in the US, it needs dollars. It may get those from its local bank, which in turn will obtain them in the international currency market. This market exists to facilitate these types of exchanges.
Puts are more or less the mirror image of calls. The put buyer expects the price to go down. Therefore, he pays a premium in the hope that the futures price will drop. If it does, he has two choices: (1) He can close out his long put position at a profit since it will be more valuable; or (2) he can exercise and obtain a profitable short position in the futures contract since the strike price will be higher than the prevailing futures price.
Whereas price extremes have no boundaries, they don't last forever, eventually commodity market supply and demand factors will bring prices back to a more equilibrium state. Accordingly, while caution is warranted at extreme levels it is often a good time to be constructing counter trend trades as it could be one of the most advantageous times in history to be involved in a market. For instance, similar to the idea of call options being over-priced when a market is at an extreme high, the puts might be abnormally cheap. Once again, your personal situation would determine whether an unlimited risk or limited risk option strategy should be utilized. Please realize that identifying extreme pricing scenarios is easy, it is much more difficult to predict the timing necessary to convert it into a profitable venture.
Currency rates are representative of the Bloomberg Generic Composite rate (BGN), a representation based on indicative rates only contributed by market participants. The data is NOT based on any actual market trades. Currency data is 5 minutes delayed, provided for information purposes only and not intended for trading; Bloomberg does not guarantee the accuracy of the data. See full details and disclaimer.