Options - THE OPTIONS MARKETS An option is a contract...

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1 THE OPTIONS MARKETS An option is a contract between two parties - a buyer and a seller - that gives the buyer the right, but not the obligation, to buy (in the case of a “ call ” option) or sell (in the case of a “ put option) a specified quantity of the underlying asset, say 100 shares of a stock, for a fixed price, termed the exercise or strike price, at or before the expiration date (called maturity) of the contract. The option buyer pays the seller a sum of money up front called the option premium , which is the option’s price. The option seller stands ready to sell or buy according to the contract terms if and when the buyer so desires. American options can be exercised at any time up to the expiration date. European option contracts can be exercised only on the expiration date itself. Most of the options that are traded on the exchanges are American. However, European options are generally easier to analyze than American options, and some of the properties of an American option are frequently deduced from those of its European counterpart. It should be emphasized that an option gives the holder the right to do something. The holder does not have to exercise the right. This fact distinguishes options from forwards and futures, where the holder is obligated to buy or sell the underlying asset. Note that whereas it costs nothing to enter into a forward or futures contract, there is a cost to entering into an option contract. Options are financial instruments that can be used to achieve a variety of investment objectives. For example, the ownership of a call (put) option allows an investor to profit from increase (decrease) in the price of a security for a fraction of the price of the security. Furthermore, since losses are limited by the size of the initial investment, the holder of the call (put) is protected against large losses that stock ownership (short selling) may involve. Options also allow investors to transfer unwanted risk associated with stock ownership to speculators willing to bear it. The necessity for transferring this risk generally reflects the investors’ reluctance to sustain large losses. Option writers are investors who accept these risks. They are enticed into selling options by the size of the premium that compensates them for these risks. The size of the premium is related to the size of possible losses, the time of coverage, and other factors. Option writers pool these risks with other risks in such a way that, in aggregate, the potential losses in their portfolios are more manageable. Exchange-Traded or Listed Options Options trade on many different exchanges throughout the world. One characteristic of these options is the standardized terms such as expiration dates, strike prices, and contract size.
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This note was uploaded on 08/28/2008 for the course FIN 545 taught by Professor Rahman during the Summer '08 term at Portland State.

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Options - THE OPTIONS MARKETS An option is a contract...

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