The theoretical value of an option can be determined by a variety of techniques. These models, which are developed by quantitative analysts, can also predict how the value of the option will change in the face of changing conditions. Hence, the risks associated with trading and owning options can be understood and managed with some degree of precision.

Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions, that have negotiated separate trading and clearing arrangements with each other. Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation.

Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Trading

The most common way to trade options is via standardized options contracts that are listed by various futures and options exchanges. By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include:

• fulfillment of the contract is backed by the credit of the exchange, which typically has the highest rating (AAA),
• counterparties remain anonymous,
• enforcement of market regulation to ensure fairness and transparency, and
• maintenance of orderly markets, especially during fast trading conditions.

Long Call

A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium paid, he will profit. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a much larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares.

Long Put

A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will profit. If the stock price at expiration is above the exercise price, he will let the put contract expire worthless and only lose the premium paid.

Short Call

A trader who believes that a stock price will decrease, can sell the stock short or instead sell, or "write," a call. Because both strategies expose the investor to unlimited losses, they are generally considered inappropriate for most investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.

Short Put

A trader who believes that a stock price will increase can buy the stock or instead sell a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock.

Options Margin Calculation

SPAN stands for Standardized Portfolio Analysis of Risk. Originally developed by the CME, SPAN is used almost universally at commodity exchanges around the world in the process of establishing option margin requirements. SPAN uses algorithms to help determine option margin requirements using a global assessment of one-day volatility and risk.

This article is licensed under the GNU Free Document licence.

It uses parts of the Wikipedia article "Option (finance)"