Types and Uses of Options
We will cover following topics
Uses of Options in Financial Markets
Options serve multiple purposes in financial markets. They provide a valuable tool for hedging, allowing investors to protect their portfolios against adverse price movements. For instance, a farmer might use options to hedge against the risk of falling crop prices. Additionally, options offer a means of generating income by selling options contracts. This is commonly seen with covered call strategies, where an investor owns the underlying asset and sells call options on it.
Moreover, options enable the creation of complex trading strategies. Investors can combine various options to create positions tailored to specific market conditions, such as straddles, strangles, and spreads. These strategies can offer opportunities for profit regardless of market direction.
Example: An airline company worried about the potential increase in fuel prices might use options to hedge against rising fuel costs. By purchasing call options on oil futures, the airline can lock in a maximum price for its fuel.
Moneyness
Understanding the concept of moneyness is essential when trading options. Moneyness categorizes options based on their relationship to the current market price of the underlying asset. There are three main moneyness classifications: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM).
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An in-the-money (ITM) option has intrinsic value and would lead to a profit if exercised immediately. In the case of a call option, if the market price is higher than the strike price, it is ITM. For a put option, the market price would need to be lower than the strike price to be ITM.
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An option is at-the-money (ATM) when its strike price is equal to the current market price of the underlying asset.
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An out-of-the-money (OTM) option has no immediate value if exercised. A call option is OTM when the market price is lower than the strike price, while a put option is OTM when the market price exceeds the strike price.
Example: Suppose an investor holds a call option with a strike price of $100, and the current market price of the underlying stock is $105. The call option is in-the-money by $5 ($105 - $100), representing its intrinsic value.
Conclusion
This chapter has provided a comprehensive overview of the types and uses of options in financial markets. Call and put options offer distinct ways to profit and manage risk, while moneyness categorizes options based on their relationship to the underlying asset’s market price. Armed with this knowledge, investors can navigate the world of options with greater confidence and precision, leveraging these versatile instruments to achieve their investment goals.