INTRODUCTION TO FINANCIAL SERVICES

Introduction to Financial Services



Introduction to Financial Services

Q: Analyse Options as Forms of Derivative Instruments

Derivatives and Options

Options are the refined form of Derivatives, in which one can go for a buy or sell positions. The trade in options is on premium. Option is a contract that provides the purchaser the right; but not the responsibility; to sell or buy an underlying at a predetermined price on or before a definite date.

Options offer the best way for investors and traders to earn the gain on equity movements without buying the principal securities, still only a few people make use of them in their own portfolios.

A Stock option which gives the possessor the right to purchase an asset at a fixed price during a certain period is called as Call Option, while an option which grants the possessor the right to sell a stock at a fixed price is a Put Option. Mackenzie (2006), describes derivatives as “a contract or security, such as an option, value of which depends upon the price of another asset or upon the level of an index or interest rate”.

Option is a contract where two parties agree upon an agreement. The agreement gives the right but not obligation to buy or sell a specific amount of currency at a specific rate on or before a maturity date from the seller of the option. The buyer of an option has right, but not obligation but if the buyer exercises the option then the seller of the option is obliged to fulfill the agreement. The seller of option charges price or option premium for giving a right.

Call Option

An asset call option gives the buyer the right to buy a specific amount of currency at a specific rate on or before a maturity date.

Put Option

An asset put option gives the buyer the right to sell a specific amount of currency at a specific rate on or before a maturity date. Since options are not obliged to be exercised they can insulate a firm from adverse movements in exchange rates, though the company may benefit from favorable currency movements. Individuals and companies typically compare the future expected cash flows of each technique of hedging before choosing which technique will be used to hedge against risk exposure.

Selling Options (against a falling market to hedge) and buy options (against a rising market to hedge) is the safest derivatives. There are four possible positions for an options trader to be in:

long a call, meaning you own the right to buy a given stock at the specified price,

Short a call, meaning you have agreed to sell the stock in question at the specified price to a buyer in the #1 position, if he exercises his right.

Long a put, meaning you have the right to sell the given stock to the person on the other side of the contract at the specified price.

Short a put, meaning you have the obligation to buy the stock in question at the specified price, ...