Option trading is an important part of the financial system. An option contract describes a sale of a security or commodity that will occur at a specified later date and at a specified price if, and only if, one party to the contract--either the prospective buyer or the prospective seller--wants to go ahead with the sale. If the contract is a "call option," the buyer has the right to decide whether or not the sale happens; if the contract is a "put option," the seller decides.
The sale price stated in the option contract is called the "exercise price." The holder of an option contract can wait until the expiration date of the contract to decide whether to exercise the option. The holder of a call option (or of a put option) will exercise the option only if the exercise price is less (or is more) than the current market price for the security or commodity--otherwise, the holder could buy the same thing at a cheaper price (or sell at a higher price) in the open market.
The holder of an option pays a premium for this valuable right when the contract is first agreed to. The other party, known as the option writer, receives the premium. Since the contract requires the option writer to sell or buy upon request of the option holder, the option holder requires the writer to post collateral in a margin account as evidence of the writer's good faith.
The price of an option--its premium--depends on several things, including the price volatility of the item to be bought or sold. As the price volatility of the security or commodity increases, the option to buy it at a fixed price in the future becomes more valuable.
Options can be bought or sold on many different items. In the United States there are option markets for shares of stock, for indexes based on stock portfolios, for foreign currencies, for bonds, for precious metals, and for FUTURES contracts on physical commodities and financial instruments.
Options are traded either through a formally organized exchange or through a less formal over-the-counter (OTC) network of dealers. Whereas option contracts have been sold for centuries, stock-option exchanges in the United States are a recent phenomenon. The oldest, the Chicago Board Options Exchange, began trading options in 1973. Other major options exchanges are in Philadelphia, New York, and San Francisco. The largest foreign-options exchanges are in London, Amsterdam, and Tokyo. In the international OTC option markets, commercial banks and broker-dealers trade options on foreign currency and debt.
Since the introduction of exchange-traded options, options-trading activity has grown tremendously, and a wide range of businesses and households trade options for hedging and speculative purposes. Along with the rise in trading volume have been equally dramatic advances in option pricing and trading techniques. The best known is the Black-Scholes option-pricing model, which values an option by identifying a strategy for trading the underlying security or commodity that results in the same payoff as the option contract.
No comments:
Post a Comment