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Understanding Financial Instrument ' Option contract '.
****Background**** Forward and Future contracts provide protection against adverse movement in price of an underlying asset ( Cryptocurrency, Foreign Exchange, Shares of a Company etc. ) buyer doesn't get benefits from favourable movement of price of the underlying asset. **Option are the financial instrument which provides protection against unfavorable movement in price of the underlying asset as well as gives benefits of favourable movement in price of the underlying asset.** ****Important Terms**** **(i) Call Option :-** An option gives to the buyer of the option, the right but not the obligation to buy an underlying asset. **(ii) Put Option** :- An option gives to the buyer of an option, the right but not the obligation to sell an underlying asset. **(iii) Strike Price ( or Exercise Price ) :-** The fixed price, at which the buyer of the ' Option contract' can exercise his opinion to buy/sell the underlying asset. **(iv) Expiry date :-** The last date on which the option may be exercised. **(v) European Option :-** An option which can be exercised only on the specified date. **(vi) American Option :-** An option which can be exercised on any date upto expiry date. ****Value of ' Option contract '**** The option contract are cash settled ( and not delivery settled ). ' Value of the Option contract on the date of maturity ' means that the option buyer receives on exercising the option. ****Example**** **Call Option** X Ltd. has purchased a 3-month Call Option of Euro with an exercise price of $1.8000. In the given example, X Ltd. has the option to buy '$' @ 1Euro=$1.8000, at the time of expiration of the contract, but not the obligation to buy '$' @ 1Euro=$1.8000. If the price of Euro is at or below $1.8000, he will not exercise the option and when price is above $1.8000, he will exercise the option because he will get '$' at lower price than the market. (i) In case when spot price of Euro is $1.7500, he will not exercise the price, value of Option is Zero. (ii) In case when spot price of Euro is $1.8600, he will exercise the option and takes the profit of $.0600/Euro. **Put Option** X Ltd. has purchased a 3-month Put Option of Euro with an exercise price of $1.8000. In the given example, X Ltd. has the option to sell '$' @ 1Euro=$1.8000, at the time of expiration of the contract, but not the obligation to sell '$' @ 1Euro=$1.8000. If the price of Euro is at or below $1.8000, he will exercise the option and when price is above $1.8000, he will not exercise the option. (i) In case when spot price of Euro in is $1.7500, he will exercise the option, and takes the profit of $.0500/Euro, ance value of Option is $0.0500. (ii) In case when spot price of Euro is $1.8600, he will not exercise the option and hence value of the Option is Zero.
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