How Do Options Work?

There are two types of option contracts: call options and put options. A call option gives the buyer the right to buy the underlying asset, while a put option gives the buyer the right to sell the underlying asset.

Moreover, depending on the option, there are two two ways for the holder to exercise his right to buy or to sell the underlying asset of the option. “European Styled” options may only be exercised on expiry date. “American Styled” options may be exercised on any trading day on or before expiry. 

Here is a simple example of how an options trade works: Daniel buys a call option contract from Laura. The contract states that Daniel will buy 100 ABC shares from Laura on the 5th of May for €125. The current share price for ABC is €130. Note that this is an example of a call option as it gives Daniel the right to buy the underlying asset.

The contract being “American Styled”, the option can be exercised up to and including the deadline, on May 5th.

If the share price of ABC is trading above €125 on May 5th, then Daniel will exercise the option and Laura will have to sell him ABC shares for €125. With ABC trading anywhere above €125 Daniel can make an instant profit by taking the shares from Laura at the agreed price of €125 and then selling the shares on the open market for whatever the current share price is and making a profit. 

The €125 value, which is stated in the agreement, is referred to as the Exercise (or Strike) Price. This is the price at which the asset will be exchanged.

The date (in this case May 5th) is known as the Expiry (or Maturity) Date. This date is the deadline for the option contract. At this date, the option buyer is to decide if a transaction of the underlying asset is to occur.

Outcomes: Let's imagine that on the expiration date, ABC is trading at €130. Then Daniel will buy the shares from Laura at the agreed €125 and then he can sell them back on the open market for €130 and make an instant €5 profit. Alternatively, if ABC is trading at €120, buying the shares from Laura at €125 is too expensive as he can buy them on the open market for €120 and save €5. In this situation, Daniel would choose not to exercise his right to buy the shares and let the options contract expire worthless. His only loss would be the amount that he paid to Laura when he bought the contract, which is called the Option Premium. Laura would, however, keep the option premium received from Daniel as her profit. - Markets Lisbon - Markets Lisbon

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