Options have becoming an increasingly important part of the financial markets, and they can be a powerful tool in many different situations. But how exactly do they work? To begin with the very basics, options are considered part of the more general group of financial instruments known as derivatives.
That's because their value is derived from that of an underlying asset, such as a stock, an exchange-traded fund, or a futures contract. Options come in two flavors—puts and calls. A call is the right to buy a stock for a given price within a given period of time, while a put is the right to sell a stock for a given price within a given period of time. The price at which the option can be exercised— in other words, the price at which the stock may be bought or sold—is known as the strike price.
And the time at which the option expires is known as the expiration date. A trader may choose to either buy or sell an option, meaning that there are four basic trades: To put it all together, then: An American option can technically be exercised prior to expiration, though that would only be done in rare situations. Read More Know your options: Intrinsic value is inherent in the price of an option—it is how much an option would be worth if it were exercised immediately.
But there's more to an option's price than its intrinsic value. An option also has time value also known as extrinsic value because there's always the chance that the stock moves more between now and its expiration date. The exact price of an option is set by demand in the market, and predicting the time value of an option is more than a bit tricky, but the main inputs are the time until expiration and the stock's volatility.
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