The fixed price at which the option buyer can either buy or sell the asset is called the exercise price or strike price.
In addition, the option has a definite life. The right to buy or sell the asset at the fixed price exists up to a specified expiration date – after which the Option expires.
The price at which the Option is available to buy or the price at which the Option can be sold is called ‘Premium’ – The decision to exercise the Option or to let it just expire will also have premium price into calculations.
The premium is adjusted with strike price (depending on if we have bought or sold call or put option), and then decision is arrived at, if it is a profitable situation.
Video: American Call Option – Payoff
Video: American Put Option – Payoff
Video: Call Option – Payoff Diagram
Although options trade in the organized markets, a large amount of option trading is traded privately between two parties who find that dealing with each other may be preferable to a public transaction on the exchange.
This type of market, called an over-the-counter market, was actually the first type of options market. The creation of an organized options exchange in 1973 reduced the interest in over-the-counter markets; however, the over-the-counter market has been revived and is now very large and widely used, mostly by the corporations and financial institutions.
Most of the options that we shall focus on trade on organized options exchange, but the principles of pricing and using options are pretty much the same, regardless of where the option trades. Most of the options of our interest are for sale or purchase of financial assets, such as stocks or bonds.
There are, however, also options on futures contracts, metals, and foreign currencies. Many other types of financial arrangements, such as lines of credit, loan guaranties, and insurance, are forms of options. Moreover stock itself is equivalent to an option on the firm’s assets.
The first trading in puts and calls begun in Europe and in the United States as early as the 18th century. In the early years the market got a bad name because of certain corrupt practices. One of these involved brokers being given options on a certain stock as an inducement for them to recommend the stock to their client.