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In order to understand equity options one must first have some knowledge of equity. Equity is the value of an asset after deducting any funds owed toward the purchase thereof. The equity of an investor’s stock portfolio is based on the value of the shares owned minus any capital lent to purchase said shares. When dealing with real estate, an owner can determine the equity of his or her property by deducting the balance of his or her mortgage from the estimated property value. Investors can use the value of their equity as collateral for loans, or as a derivative that can be traded on the open market.
Equity options are contracts negotiated between a seller, or option writer, and a buyer, or option holder, based upon the exchange of securities at a given price, or strike price. There are two types of equity options: call options and put options. Call options grant the buyer the right to follow through with the purchase of a security at a given time based upon the established strike price. Those who buy call options are hoping that the value of the security will rise by the time they follow through with their purchase. When a contract for a call option is struck, the buyer can chose to follow through with the purchase at the specified time or opt out, but the seller is obligated to honor the transaction regardless.
Put options are contracts between the owners of an instrument, or put writer, and an investor, or put holder who believes the value of that instrument will fall during a span of time known as the exercise period. The put holder pays the strike price plus a premium value for a security. If during the exercise period the value of that security does fall, he or she can then sell the equity option back to the put writer for the original strike price.
The put writer hopes the value of his or her asset will increase so that he or she would profit from the sale’s premium. A put holder wishes for the value of that asset to fall below the value of the strike price so that he or she may force the writer to buy back the equity option at the strike price. Speculators often use this practice and the risk level is quite high. Most often equity options are put options where the owner of a security is hoping to generate quick income from the premium price charged for the sale of the put option.
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