Factors That Determine Option Pricing

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Instrument models[ edit ] The terms for exercising the option's right to sell it differ depending on option style.

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A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration. The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long position in it.

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The advantage of buying a put over short selling the asset is that the option owner's risk of loss is limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller's loss.

The put writer believes that the underlying security's price will rise, not fall.

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The writer sells the put to collect the premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already received.

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Puts can be used also to limit the writer's portfolio risk and may be part of an option spread. That is, the buyer wants the value of the put option to increase what is profit in binary options a decline in the price of the underlying asset below the strike price.

The writer seller of a put is long on the underlying asset and short on the put option itself.

The Bottom Line Options can be used in a wide variety of strategies, from conservative to high risk. Key Takeaways Options are derivative contracts the right, but not the obligation, to buy for a call option or sell for a put option some asset at a pre-determined price on or before the contract expires. Options can be used for directional strategies or to hedge against certain risks in the market.

That is, the seller wants the option to become worthless by an increase in the price of the underlying asset above the strike price. Generally, a put option that is purchased is referred to as a long put and a put option that is sold is referred to as a short put.

  • A call option is in the money ITM when the underlying security's current market price is higher than the call option's strike price.
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A naked put, also called an uncovered put, is a put option whose writer the seller does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock, but only if the price is low enough. If the buyer fails to exercise the options, then the writer keeps the option premium.

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If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner buyer can exercise the put option, forcing the writer to buy the underlying stock at the strike price. That allows the exerciser buyer to profit from the difference between the stock's market price and the option's strike price. But if the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless, and the owner's loss is limited to the premium fee paid for it the writer's profit.

The seller's potential loss on a naked put can be substantial.

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If the stock falls all the way so take an option zero bankruptcyhis loss is equal to the strike price at which he must buy the stock to cover the option minus the premium received. The potential upside is the premium received when selling the option: if the stock price is above the strike price at expiration, the option seller keeps the premium, and the option expires worthless.

During the option's lifetime, if the stock moves lower, the option's premium may increase depending on how far the stock falls and how much time passes. If it does, it becomes more costly to close the position repurchase the put, sold earlierresulting in a loss.

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If the stock price completely collapses before the put position is closed, the put writer potentially can face catastrophic loss. In order to protect the put buyer from default, the put writer is required to post margin.

The put buyer does not need to post margin because the buyer would not exercise the option if it had a negative payoff.

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Example of a put option on a stock[ edit ] Payoff from buying a put. Payoff from writing a put.

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Buying a put[ edit ] A so take an option thinks the price of a stock will decrease. They pay a premium which they will never get back, unless it is sold before it expires.

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The buyer has the right to sell the stock at the strike price. Writing a put[ edit ] The writer receives a premium from the buyer.

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If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer's profit is the premium. Trader A's total loss is limited to the cost of the put premium plus the sales commission to buy it.

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A put option is said to have intrinsic value when the underlying instrument has a spot price S below the option's strike price K. Upon exercise, a put option is valued at K-S if it is " in-the-money ", otherwise its value is zero. Prior to exercise, an option has time value apart from its intrinsic value.

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The following factors reduce the time value of a put option: shortening of the time to expire, decrease in the volatility of the underlying, and increase of interest rates. Option pricing is a central problem of financial so take an option.

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Trading options involves a constant monitoring of the option value, which is affected by changes in the base asset price, volatility and time decay. Moreover, the dependence of the put option value to those factors is not linear — which makes the analysis even more complex.

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The graph clearly shows the non-linear dependence of the option value to the base asset price.