Options as an Investment

Investment and Portfolio Management – BAF106Investment and Portfolio Management – BAF106

OPTIONS AS AN INVESTMENT


Market Interest Rate Analysis

Essentials of options:

Option is a type of contract between 2 persons where one person grants the other person the right to buy or to sell a specific asset at a specific price within a specific time period. The most often options are used in the trading of securities.

Option buyer is the person who has received the right, and thus has a decision to make. Option buyer must pay for this right.

Option writer is the person who has sold the right, and thus must respond to the buyer’s decision.



Types of option contracts:

Call option. It gives the buyer the right to buy (to call away) a specific number of shares of a specific company from the option writer at a specific purchase price at any time up to including a specific date.

Put option. It gives the buyer the right to sell (to put away) a specific number of shares of a specific company to the option writer at a specific selling price at any time up to including a specific date



Option contract specifies four main items:

1) The company whose shares can be bought or sold;

2) The number of shares that can be bought or sold;

3) The purchase or selling price for those shares, known as the exercise price

(or strike price);

4) The date when the right to buy or to sell expires, known as expiration date



Types of call and put options:

European options can be exercised only on their expiration dates.

American options can be exercised any time during their life (defined by the option contract).



The major advantages of investing in options:

possibility of hedging: using options the investor can “lock in the box” his/ her return already earned on the investment;

the option also limits exposure to risk, because an investor can lose only a set amount of money (the purchase price of option);

put and call options can be used profitably when the price of the underlying security goes up or down.

The major disadvantages of investing in options: the holder enjoys never interest or dividend income nor any other ownership

benefit;

because put and call options have limited lives, an investor have a limited time frame in which to capture desired price behavior;

this investment vehicle is a bit complicated and many of its trading strategies are to complex for the non-professional investor.

Options as an Investment

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