73323219-8-Mechanics-of-Options-Markets

73323219-8-Mechanics-of-Options-Markets - T ER Mechanics of...

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TER Mechanics of Options Markets We introduced options in Chapter 1. This chapter explains how options markets are organized, what terminology is used, how the contracts are traded, how margin requirements are set, and so on. Later chapters will examine such topics as trading strategies involving options, the determination of option prices, and the ways in which portfolios of options can be hedged. This chapter is concerned primarily with stock options. It presents some introductory material on currency options, index options, and futures options. More details concerning these instruments can be found in Chapter 14. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something, but the holder does not have to exercise this right. By contrast, in a forward or futures contract, the two parties have committed themselves to some action. costs a trader nothing (except for the margin requirements) to enter into a forward or futures contract, whereas the purchase of an option requires an up-front payment. 8.1 TYPES OF OPTIONS As mentioned in Chapter 1, there are two basic types of options. A call option gives the holder of the option the right to buy an asset by a certain date for a certain price. A put option gives the holder the right to sell an asset by a certain date for a certain price. The date specified in the contract is known as the expiration date or the maturity date. The price specified in the contract is known as the exercise price strike price. Options can be either American or European, a distinction that has nothing to do with geographical location. American options can be exercised at any time up to the expiration date, whereas European options can be exercised only on the expiration date itself. Most of the options that are traded on 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. Call Options Consider the situation of an investor who buys a European call option with a strike price of $100 to purchase 100 eBay shares. Suppose that the current stock price is $98,
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182 CHAPTER 8 the expiration date of the option is in 4 months, and the price of an option to purchase one share is $5. The initial investment is $500. Because the option is European, the investor can exercise only on the expiration date. If the stock price on' this date is less than $100, the investor will clearly choose not to exercise. (There is no point in buying for $100 a share that has a market value of less than $100.) In these circumstances, the investor loses the whole of the initial investment of $500. If the stock price is above $100 on the expiration date, the option will be exercised. Suppose, for example, that the stock price is $115. By exercising the option, the investor is able to buy 100 shares for $100 per share.
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This note was uploaded on 01/30/2012 for the course MATH 174 taught by Professor Donblasius during the Spring '11 term at UCLA.

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73323219-8-Mechanics-of-Options-Markets - T ER Mechanics of...

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