Boundary Conditions

  

Categories: Derivatives, Trading

An option is an investor's way of making a bet that the price of a stock will go up (a call option) or down (a put option).

Options investors usually set boundary conditions, meaning a maximum and minimum price for the “underlying asset” (such as a stock) for the call or put options. The investor would most likely set the maximum value as the current price of the stock. If that price is greater than the call option boundary, the investor would not exercise the option, since he or she would lose money paying the current market price.

Same deal, more or less, for put options. If the price of the stock stays above your lowest boundary, you would not exercise the option, since you're waiting for it to drop down to a given price.

Let’s say you have your eye on the stock for Desktop Throwbacks, LLC, and are willing to buy if it goes down to $25. You could sit around and wait for this to happen (sounds relaxing), but a better use of your money might be to sell a put option, setting the boundary at the current market price of $28.

If the price stays at or above $28, the option buyer would not force you to pay that amount, and the option would expire. If it does go down to $25, you get the shares at the price you wanted. Yippee.

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finance a la shmoop. what is a call option? option? option, where are you? okay

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yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]

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is the right to call or buy a security. the concept is easy the math is hard.

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you think Coca Cola's poised for a breakout as they go into the new low

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calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]

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to then buy coke stock at 55 bucks a share anytime you want in the next

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hundred and 20 days. so let's say Coke announces its new sugarless drink flavor

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zero it's two weeks later and the stock skyrockets to fifty eight dollars a

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share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]

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so you buy the stock and you're all in now for fifty five dollars plus one or

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fifty six bucks a share and your total value is now fifty eight bucks. well you

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could turn around today and sell the bundle that moment, and you'll have

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turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]

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stock not skyrocketed so quickly well you would have lost everything. still you

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lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]

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options. as for Coke flavor zero turned out to be nothing more than canned water.

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