Financial Daily from THE HINDU group of publications
Sunday, Jun 20, 2004
Financial Daily from THE HINDU group of publications Sunday, Jun 20, 2004 |
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Investment World
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Derivatives Markets Markets - Derivatives Markets Derivatives: First principles
What are options? An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities such as wheat, rice, cotton, gold and oil or financial instruments such as equity stocks, stock index and bonds. What is assignment? When holder of an option exercises his right to buy or sell, a randomly selected option seller is assigned the obligation to honour the underlying contract, and this process is termed as assignment. What are European & American Style of options? An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry. The European kind of option is the one, which can be exercised by the buyer on the expiration day only and not anytime before that. How are options different from futures? The significant differences in futures and options are as under: Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy or sell the underlying asset. In case of options the buyer enjoys the right and not the obligation to buy or sell the underlying asset. In case of options, the buyer enjoys the right and not the obligation to buy or sell the underlying asset. Futures contracts have symmetric risk profile for both the buyer as well as the seller, whereas options have asymmetric risk profile. In case of options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer. The futures contracts prices are affected mainly by the prices of the underlying asset. The prices of options are, however, affected by prices of the underlying asset, time remaining for expiry of the contract and volatility of the underlying asset. It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as premium. Source: www.bseindia.com
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