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Options give the buyer the right but not the obligation to buy or sell an asset (underlying) on a future date at a pre-set price (strike price). A fee (premium) is generally paid upfront for this flexibility. There are two types of options:
Call: it grants the buyer the right to buy the underlying asset at a predetermined price. It can be exercised when the market prices are higher than the predetermined price.
Put: it grants the buyer the right to sell the underlying asset at a predetermined price. It can be exercised when the market prices are lower than the predetermined price.
Option contracts have an expiry date by which the owner has the right to buy the underlying asset (call) or sell it (put). Different categories of options can be identified depending on the expiry:
American options – The right to buy or sell can be exercised at any time prior to and including the expiry date.
European options – The right to buy (call) or sell (put) the underlying asset can be exercised only on the expiry date.
These options are structured differently from American and European options in terms of the underlying formula, or of the assessments of how or when the investor receives a given payoff. Some examples of such options are:
Asian options – Options in which the payoff is determined by the average price of the underlying in a predetermined period of time.
Bermudan options – Options that can be exercised only on specified dates, usually every month, by the expiry date.
Barrier options – Options that can be exercised by the holder only if the underlying reaches (or does not reach, depending on the terms of the contract) a certain price level (barrier) during the life of the option.
Binary options – Options that pay an agreed amount if the underlying meets a pre-defined condition upon expiry. If this is not the case, it expires without any value.
European options are the most common power options, however also Asian options are quite common in countries like Italy and Spain.
The exposure of a physical position can be replicated in exchange for a premium.
They can be used in multiple ways to create customized positions and cover risks.
Risk reduction (for the buyer)
No exposure to adverse price movements: the premium constitutes the maximum loss.
The graph shows the value at expiration of option contracts. This value (y axis) is obtained through the possible exercise of the option. For example, in the case of the purchase of a call, the value of the contract at expiration will be higher when the difference between the value of the unerlying and the strike is bigger. If at expiration the value of the underlying is lower than the strike, the value of the contract will be zero because the option is not excercised.