Introduction to Financial Derivatives - Option Contracts

To quickly reiterate, there are the following four basic derivatives:

- Forward contracts
- Futures contracts
- Swap contracts
- Option contracts

In this post we will look at option contracts.

Option Contracts
An option contract grants its holder the right, but not the obligation, to buy or sell something at a specified price, on or before a specified date.

A simple example:
You are interested in a company's stock (let's say ABC company). You believe that the stock is undervalued and will increase over the next several months. You decide to enter into an option contract which grants you the right (but remember... not the obligation!!!) to buy the stock for the current price in 6 months time. In six months time, if the price of the stock has increased, you exercise the option and you buy the stock at the price you "locked" six months ago. The gain is the difference between the current price and the price you paid. If the price has decreased, then you let the option to expire without exercising it since you can buy the stock at less than the "locked" price.

* One of the main differences between the option contract and the rest of the derivatives is the premium price you pay in order to enter the option contract. For the rest of the contract no premium is involved.


This post completes the introduction to the four basic derivatives!!!
I hope you enjoyed it...