Stock options are becoming an increasingly attractive proposition for options trading in Pakistan companies. As an investor, you can buy or sell a stock option that gives you the right to buy or sell several stocks at a predefined price within a specific period. The company has already used this technique to raise money and make deals with other companies.
European and American options
The two types of options are: European and American. A European option allows the holder to exercise his rights only on the expiration date. In contrast, in American options, any time before its expiration, one can decide whether he wants to exercise it or not.
However, in both cases, it cannot be reversed once exercised. Another differentiating factor is that in the case of European options, the stocks are delivered only on the expiration date. In contrast, in American options, the physical transfer takes place earlier, i.e. any time before its expiration date.
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The possibility of making money through stock options depends on price movements of underlying security because if at any point of life cycle it reaches anywhere above or below the exercise price, then either you can buy (call) or sell (put) them depending upon whether you hold call option or put option to make money.
Holding American options
Similarly, if you hold an American option and stock prices rise above the exercise price of these options, they would become In The Money. In contrast, if prices fall below the exercise price, these options will become Out Of The Money.
For both European and American options being In The Money means that their intrinsic value is greater than zero, i.e. difference between current market price and exercise or strike price is favorable for call options and unfavorable for put options. These in-the-money options have a real chance of expiring with a positive value for the buyer but a negative value for the writer.
Money made and lost
The amount of money you make or lose will depend on how much the market price has moved. You’ll get to know the intrinsic value of your option using this simple formula: Intrinsic Value (IV) = Current Stock Price – Exercise/Strike Price
With time, as an option moves toward its expiration date, all the three components, i.e. time value, volatility and the risk-free rate, tend to zero. The only thing that remains is IV which becomes more and more significant with every passing day. It will turn either positive or negative for call and put options depending upon whether their IV turns out to be higher than exercise/strike price or lower than it, respectively.
For any expiry date, there are two possible outcomes for call options: Intrinsic value = Exercise/Strike Price + 0 (which is always positive)
If the IV is above the exercise price, you can sell your stocks higher than what you paid for it and make money. Otherwise, intrinsic value = Exercise/Strike Price -0 (negative). If this happens, the option will expire worthless while you still hold the obligation of making payment under the contract.
But in the case of put contracts, nothing exceptional happens if IV turns out to be negative. You repurchase them at market price, which is less than your original purchase price. Thus, you lose money making this transaction itself, i.e. net loss on transactions.
There is one significant difference between these options because even though the market price is lower than exercise/strike prices, you can still buy stocks at market prices, i.e. less than what you paid for it originally.
Thus, if IV is greater than or equal to exercise price and negative put options expire worthless and initial loss on the transaction will be offset by the possibility of buying the same stock at lower market value.
In contrast, in the case of call options, although the market price is higher than the strike price, there is the possibility of selling them again at higher market value, giving you the overall positive result, which makes them superior instruments compared to put contracts.
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