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Stock option

option

In finance, the derivative instrument known as an option will give its owner a right but no obligation.

Examples:

  • You own a call stock option. This gives you the right, but not the obligation, to purchase the underlying shares for a predetermined price, in accordance with the rules found in the term sheet of the option. If you decide to go ahead with the purchase, it is called exercising the option.
  • You own a put stock option. This gives you the right, but not the obligation, to sell the underlying shares for a predetermined price, in accordance with the rules found in the term sheet of the option. If you decide to go ahead with the sale, it is called exercising the option.

When can I exercise my option?

The answer to this question is found in the term sheet of the option.

 

optionsIf it is a standard American-style stock option, you can elect to exercise it on any day until the option has expired.

 

If it is a standard European-style stock option, it can only be exercised on its expiry date.

 

Options that are neither American-style nor European-style are known as exotic options. One of the most well-known of the exotic-styles is the Bermuda-style option, which can only be exercised on certain dates as stipulated in the term sheets, e.g. only on 15 January, 15 April, 15 July and 15 October.

 

Another example of an exotic-style option is the barrier stock option. A barrier stock option can only be exercised if the market price of the underlying stock passes a certain point (the barrier).

Important words to know when investing in stock options

Word Explanation
Premium The price you pay for the stock option when you buy it.
   
Strike price The price the holder of a call stock option pays per share when exercising the option or the price the holder of a put stock option receives per share when exercising the option.
   
Binary Option A binary option works very differently from a regular option. They allow you to speculate on future market movements.  The return of a binary option is not dependent on the market value of the underlying financial instrument.  The return is predefined. You always get the same return provided that the option matures in the money. You can learn more about binary options here.
   
Writer The creator of a stock option. The writer is obliged to honour the stock option, should the holder of the stock option elect to exercise it.

The settlement terms (in the term sheet) will determine if the writer is obliged to actually deliver or take delivery of shares, or if the writer is allowed to cash-settle the option instead.

Exchange-traded stock options are typically cash-settled through a clearing-house, which means that the writer and the holder has no contact with each other.

What is the Black–Scholes model?

If you start trading in stock options, you will probably come across references to the Black-Sholes model sooner or later.

 

The Black-Sholes model is a mathematical model of a financial market containing derivative instruments (such as stock options). From this model, it is possible to deduce the Black-Sholes formula. This formula gives a theoretical estimate of the price of European-style options.

 

The Black-Sholes model was published by Fisher Black and Myron Scholes in 1973. It gained widepsread attention among investors when the paper “The Pricing of Options and Corporate Liabilities” appeared in the Journal of Political Economy.

 

The formula provided mathematical legitimacy to options markets and helped fuel a boom in options trading in the 1970s.

 

Today, the Black-Sholes formula is still widely used by investors, albeit often with adjustments and corrections. Empirical studies have shown that the Black-Sholes price tend to be fairly close to the actual market price.