Define call option and put option
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset a stock or index at a specific price on or before a certain date listed options are all for shares of the particular underlying asset.
An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties. For most casual investors, that definition may as well be written in ancient Greek. There are only two kinds of options: Then you can either keep the shares which you obtained at a bargain price or sell them for a profit.
But what happens if the price of the stock goes down, rather than up? You let the call option expire and your loss is limited to the cost of the premium. When you hold put options, you want the stock price to drop below the strike price.
If it does, the seller of the put will have to buy shares from you at the strike price, which will be higher than the market price. Because you can force the seller of the option to buy your shares at a price above market value, the put option is like an insurance policy against your shares losing too much value.
The seller or "writer" is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee called a premium for this right. The term "call" comes from the fact that the owner has the right to "call the stock away" from the seller.
Option values vary with the value of the underlying instrument over time. The price of the call contract must reflect the "likelihood" or chance of the call finishing in-the-money. The call contract price generally will be higher when the contract has more time to expire except in cases when a significant dividend is present and when the underlying financial instrument shows more volatility.
Determining this value is one of the central functions of financial mathematics. The most common method used is the Black—Scholes formula.
Importantly, the Black-Scholes formula provides an estimate of the price of European-style options. Adjustment to Call Option: When a call option is in-the-money i. Some of them are as follows:. Similarly if the buyer is making loss on his position i. Trading options involves a constant monitoring of the option value, which is affected by the following factors:. Moreover, the dependence of the option value to price, volatility and time is not linear — which makes the analysis even more complex.