In finance, the term option refers to a derivative which gives its holder the right to purchase or sell its underlying assets on or after a predetermined maturity date.
The holder of an option is under no obligation to buy or sell its underlying assets when the option matures, but they have the right to do so if they choose to.
Options are used to invest in assets while minimizing the risk of loss. Options give their holder the right to buy assets at a certain point in time, but do not obligate them to do so. Because of this, they can be used to speculate on future increases or decreases in the value of assets without actually investing in the assets and bearing the risk of loss.
When an option is created, the issuer and the investor agree on a strike price – the price which they option entitles the investor to pay for the underlying asset.
Options issuers charge premiums for options contracts. Option buyers pay these premiums for the options themselves, so they apply whether or not the option is exercised after it matures.
Example of using an option as an investment vehicle:
An investor believes that the value of a software company stock will skyrocket from its current 45 Swiss francs per share to upwards of 90 francs per share after its new online service is launched at the beginning of the following year. However, there is also a risk that the product will flop and the company’s stock will collapse. Rather than buying 10,000 shares in the company and then hoping their value will increase when the product is launched, the investor chooses to buy an option which gives them the right to buy 10,000 shares in the company at a strike price of 50 francs per share on a date shortly proceeding the product launch. The investor pays an option premium of 0.20 centimes per underlying share or 2000 francs total.
By the time the option matures, the value of the underlying shares has climbed to 87 francs per share thanks to the successful launch of the company’s new online service. Because the value of the underlying stock is far higher than the option’s strike price, the option is in the money. The investor exercises the option and buys the 10,000 shares from the issuer for 50 francs per share as agreed in the option contract. They then sell the shares at the going rate of 87 francs per share, bagging a 37-franc profit on each share or 37,000 francs total profit. After deducting the option premium from the profit, the investor has still made a gain of 35,000 francs.
If, on the other hand, the product had flopped and the underlying stock’s price had not climbed past the 50-franc option strike price, the option would have been out of the money. The investor could then choose not to exercise the option because they would pay more for the shares by buying them at the option strike price than they would pay on the open market. Options which are not exercised when they mature are known as abandoned options.
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