Options are covered under the online course on Impact Bonds. First published as part of Impact Bonds online course, this note shares a brief overview of the global options market. Options are derivative instruments. Derivatives are financial instruments whose value is based on an underlying asset. This asset could be a tradeable asset like listed shares of a company or derivatives on art or illiquid assets. They are two types of options; Call Option gives the holder the right but not the obligation to buy an asset at a specific price over a time period. Put Option gives the holder the right but not the obligation to sell an asset at a particular price over a time period. Options can be traded on over the counter or on exchange. The over-the-counter derivatives market is much bigger than the exchange traded derivatives market. The Global OTC Derivatives Market gross market value stood at $12.617 trillion at end of H1 2021, the notional amount at ~$610 trillion according to BIS data.
Options have an exercise price or strike price K built into the contract. For example Twitter is trading at $45.85. Let’s assume the option price on the Twitter stock is 1.76 for a strike price of 50. You buy options in lots i.e. options on 50, 100 stocks, etc. Ignore any other information, taking the maturity of the call option to be a month, you will buy a Twitter stock only if the stock crosses (50+1.76) = 51.76, otherwise you will not use the option. If you do not use the option, the 1.76 premium paid per stock will be your loss. If the stock trades at 55, you will buy the stock at 50 and sell it in the market for 55, making a profit of 55-50-1.76 = $3.24.
There are two types of options American and European. American options can be exercised at any time during the life of the option, the European option is exercised only at the end of the maturity. The period of the option is known as expiration date or maturity, the price of the derivative contract is exercise price or strike price. Options trading on the exchanges are standardized and much more liquid than an option that is traded over the counter. These options are known as plain vanilla options.
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