A Note on Investment Strategies Involving Options

Abstract

The note discusses some of the basic definitions often used in option contracts. It covers in detail the various investment strategies involving options. The objective of this note is to make the reader understand better the potential of options as an investment tool and how an options strategy can be designed to take advantage of certain market conditions.

Options on commodities have existed in different forms since 1860 for products including gold, wheat and tulip bulbs. However, large-scale manipulation by intermediaries and absence of standardized contracts resulted in investors incurring heavy losses due to which trading in commodity options were discontinued by many exchanges by 1968.

An option is the right, but not an obligation, to buy or sell a specific commodity on or before a specific date for a specific amount. Options are of two basic types - Call and Put. A call option gives the option holder the right, but not an obligation, to buy a given amount of an underlying asset on or before a certain date for a specified price. However, the seller of the option is under an obligation to fulfill the contract for which a price is paid by the call option holder, which is known as call option premium. A put option gives the option holder the right to sell a given amount of an underlying asset on or before a certain date at a specified price. The seller of the option is under an obligation to fulfill the contract and is paid a price known as the put option premium. An option contract may involve taking a 'long position' or a 'short position' or both. An investor is said to have taken the long position when he/she has bought an option. On the other hand, an investor is said to have taken a short position when he/she has sold or written the option.

While discussing option contracts, it is important to understand some other terms that are often used. Strike or Exercise Price is the price at which the underlying asset would be bought at a particular date in the future. The date on which the option holder exercises his right to sell/buy the option is known as the Exercise Date while the date on which the option expires is known as Expiration Date.

Options can be categorized further according to the date of exercise. A European Option can be exercised only on the maturity date while an American Option can be exercised before or on the maturity date. A Bermudan Option is a combination of the American and European option and is exercisable only on certain specified days during its entire life. In Cash settled option buyer is paid the difference between the stock price and the exercise price (in the case of a call option) or between the exercise price and the stock price (in the case of a put option). In a Delivery settled option buyers take the delivery of the underlying security (in the case of a call option) or offers the delivery of the underlying security (in the case of a put option)............

        Case Code   MISC003
   Case Length    17 Pages
              Period    1973 - 2003
 Organization    
        Pub Date      2003
Teaching Note     Not Available
     Countries     
      Industry    

Issues

Basic definitions, option contracts, investment strategies, option, reader, potential, investment tool, market conditions.