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 Derivatives are a relatively new and growlingly important class of financial assets. They are securities that provide payoffs depending on the value of the underlying assets. Futures and options are two examples of derivative securities. Options are written on common stock, stock indicies, foreign currencies, interest rates, precious metals, weather, and agricultural commodities.
A call option gives its holder the right to purchase the underlying asset for a sepcified price, also referred to as strike price or exercise price, prior to the expiration of the contract. For example, a November call option on IBM's stock with a strike price of $100 entitles the owner to purchase IBM stock for $100 up until the expiry date of the contract. The holder is not obligated to exercise the option and can let it expire.
It would be profitable for the owner of the call option to exercise it only if the market price of the underlying asset is greater than the exercise price. The holder can either sell the call options for a profit, or call away the underlying asset. When this is not the case, the holder can simply let the call option expire, not taking any action on the underlying stock as the call option as no value.
A put option gives its holder the right to sell an asset for a specified price on or before the expiration date. For example, a December put option on IBM's stock with an exercise price of $100 entitles the owner to sell IBM stock to the put writer for $100 at any time prior to the expiration date. Profits on a call option increase as the value of the unerlying asset decreases. The put option is only exercised if its holder can deliver an asset with market value less than the exercise price written on the contract.
The purchase price of the option is called the premium. It represents the compensation the purchaser of the put or call option pays for the ability to exercise the option, if it becomes profitable. The seller of a call option writes the call, and receives a premium upfront for the possibility that they would have to sell a security to the holder. The oppposite holds true for the writer of a put option.
An option is said to be in the money when its exercise would produce a profit, and is referred as out of the money when the exercise would not be profitable. For a call option, it would be in the money when the exercise price is below the market price, and would be out of the money when the market price is higher.
Similarly a put option would be in the money if the exercise price is higher than the current market price, and out of the money when the exercise price is lower than the market price of the underlying asset. An option is at the money when the exercise price equals the market value of the asset.
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