An option is a contractual agreement entered into by two parties – a seller and a buyer- giving the buyer the right and not the obligation, to purchase or sell a commodity at a later date at an already agreed upon price today. See option as ‘freedom to either do a thing or not to do it’
Notice the use of the word ‘right’ and not ‘obligation’. What this means is that a buyer or seller can at anytime before the expiration of the contract decide to back out without incurring any legal action upon him or her self. Buyers seem to be favored more in option trading than the sellers. The option seller is ready to sell or buy according to contract terms if and whenever the buyer so desires.
What the buyer of an option pays the seller of the option is known as the price or premium.
A CALL is used to describe an option made for buying something while a PUT is used to describe the option made for selling something.
DO OPTIONS HAVE AN ORGANIZED MARKET?
In as much as options trade in an organized market, the fact still remains that large amount of options trading are done privately over the counter. Organized options exchange was created in 1973, but that does not stop people from privately contracting with each other to trade options.
HOW ARE OPTIONS PRICED?
Options are priced with help of models. A model is a simple way of representing an otherwise complex realities; making use of certain inputs to produce verifiable output. This can be done manually or by the use of electronic devices such as computer. An option pricing model makes use of inputs from known variables to get output – theoretical fair value of the option. Various models exist but the most common ones are: (1) binomial option pricing model, and (2) Black-Scholes options pricing model.
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To your successful options trading!