What is an Option?


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It is always worthwhile to keep your options open. That trustworthy advice applies to the world of international finance as well. There is always value in having the right, but not the obligation, to buy or sell something at a guaranteed price at the end of each season if the price in the future.

A racehorse owner with an option to buy a new thoroughbred at a certain price could exercise that option with great profit if the horse were to win the Kentucky Derby. A sheep farmer in New Zealand could profit from having the option to sell wool at a guaranteed price at the end of each season if the price of wool were to fall precipitously.

In the financial markets, where nothing of value is free, options-logically-cost money. The seller of the option has to be paid for taking the risk that the option will be exercised, or used at some time in the future.

One of the biggest advantages of buying an option is that investors know they will never lose more than a price they originally paid for the option. If wool prices in New Zealand end up higher than the level guaranteed by the purchase option the New Zealand farmer can choose to let the call option expire and sell wool on the open market at higher price.

The most important factor in determining an option’s value is the likehood of it being used. An option that no one expects to be exercised costs very little. However, an option will naturally be quite expensive if there is a good chance of its being exercised. An option to buy a ton of umbrellas would be more expensive just before a London rainstorm than during a dry spell in Los Angeles.

Options can be created for anything that has uncertainty. For example, since no one knows for sure if a stock’s price will go up or go down, it is worthwhile having an option to sell a given stock at a fixed price in the future. If its price moves in the right direction, the holder of a stock option will profit handsomely by exercising that option-or by selling it to someone else.

An option’s value essentially depends on the movements in value of underlying the assets. But two other factors also influence an option’s value: volatility, the amount of movement of the underlying asset, such as dot-com stock, is worth much more than one based on a stock that hardly ever changes in value. Likewise, an option that can be exercised over several years is much more valuable than one be can be exercised for only a few days.

Because options are much more volatile than the underlying assets on which they are based, investors need to be especially careful with them. Buying an option is not same as buying a stock. It can rise exponentially in value, or it can become worthless within a matter of weeks. Because a stock option, for example, represents the right to buy or sell a large number of shares of underlying stock, its price moves much more quickly.

The world’s first options were used in early agrarian societies, where options in the form of handshake agreements allowed farmers to hedge against the fluctuating price of commodities such as wheat or grapes. In the expanding global economy, options and options market from Chicago to Hong Kong, from Melbourne to London have grown to include a vast cornucopia of products, including foreign currency options and options on other financial instruments such as stock indexes, futures, and interest rate.


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