Futures And Options Market Critical Thinking Samples
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1. Call option allows its holder to buy an asset at a specified (exercise, or strike) price within a definite time period, until the option’s expiration. Buying a call option is an attractive way of trading. The buyer is not obliged to purchase the asset but can exercise his right for purchase whenever he considers the asset’s value is moving well enough beyond the exercise price to generate good returns for him. Buying a call option is based on the buyer’s assumption that the value of the asset underlying the option will grow up before the expiration date (Hull, 2013). The put option, on the contrary to the call option, allows its holder to sell the asset at a specified price within the definite time period, until the option’s expiration. Writing, or selling puts, involves more risk as for the writer (seller) it is associated with the obligation to buy an underlying asset at the exercise (strike) price. This risk is compensated to the seller by a premium. Writing a put option is based on the seller’s speculation that the value of the asset will move down, so the option will not be exercised and the seller will earn profit on this premium (Hull, 2013).
2. Financial derivatives pricing is based on the assumption that the buyer’s gains equal the seller’s losses. In this sense, the total position of all contracts in a financial derivatives market gives a zero sum (ignoring transaction costs) (Kolb & Overdahl, 2009). So called no-arbitrage principle of financial derivatives market (no profit without investment) is based on both the buyer’s and seller’s awareness of zero-sum market position. Signing the contract for their interest, neither party would agree to invest the funds in the contract which will bring profits to the other party. If one party could earn profit without investing funds, it would signify the other party should experience a loss equal to first party’s profit. One party goes to a long position, and the other for a short position for each new contract introduced to the market; so the transfer of risks from one party to another takes place, equalling to the net position of zero. All pricing strategies for derivatives take into account this zero-sum concept (Kolb & Overdahl, 2009).
References
1. John C. Hull (2013). Fundamentals of futures and options (8th ed.).Toronto: Pearson Canada.
2. Kolb, R.W., & Overdahl, J.A. (2009). Financial Derivatives: Pricing and Risk Management. Hoboken, NJ: John Wiley & Sons, Inc.
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