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Options are contracts that give the owner the right, but not the obligation to buy or sell specific assets (underlying securities) at predefined price - strike price on the expiration date of contract. The buyer is obliged to pay the seller the amount of money that represents the cost of options (known as option price), which is also called a premium. If the option gives the owner the opportunity to buy assets, this option is called "call", otherwise it is a called "put" option.

According to the date of expiration, there are two types of options: American type and European type. These two types of options have nothing to do with geographical use, but with the way how they are traded. American type option allows the holder to execute option on any day until the date of expiration, while European type allows execution strictly on the day of expiration. With the American type option, if the holder does not execute option until the expiration date (including expiration date), the option becomes void.

Each option contract must contain the following elements:

- Type of contract (sales or buy)

- Type of option (American or European)

- Underlying security

- Unit of trading

- Strike price

- Expiration date of the contract

There are three prices essential for options: the price of underlying security, premium and strike price.

The premium is the price that the buyer pays to the option holder. In case of call option premium price represents the maximum amount that the buyer can lose if he does not use the option, or the maximum profit that the seller can achieve. If the buyer executes the call option, the seller is obliged to deliver to him the underlying security at the strike price.

Strike price is the price of the contract used for buying or selling underlying security at the date of maturity. It is a constant and does not change the whole period of validity of an option contract. If the strike price of the call option is less than market price, or greater in case of put option, the option is said to be "in the money", otherwise it is "out of the money". In special case when strike price and market price are the same, option is "at the money".

Price of options (premium) is formed at the market and it represents the sum of the intrinsic value and time premium. The value of the premium depends on a number of factors:

  • Market price of underlying security - option price is directly dependent on the price of underlying security. When the price of underlying security increases, prices of call options are rising too, but prices of put options decline. It is logical, because as the price of underlying security is higher, sellers of call options will require more money because their loss will be larger.
  • Time left until the maturity date - a long expiration time causes higher time premium, so the value of the option is higher. Higher time range increases the probability that price of underlying security will change, so possibility that the buyer will make profit is greater.
  • Risk of underlying security - if underlying security has more risk, its price is unstable se expected premium is higher. Thus, the high cost of options indicates the instability of the basic market.
  • Strike price - the strike price is fixed, but the ratio of its value and current market value may affect the amount of the premium.
  • Interest rate risk - changes on interest rate lead to changes in prices of underlying security, therefore it has affect on option price.
  • Dividends - dividends are not paid for the option holders, but to the holder of securities. The higher dividends make options less attractive.

Depending on underlying security options can be:

  • Options on shares;
  • Options on bonds;
  • Options on interest rates;
  • Options on currencies