Options - Part A European Option, American Option

Reading 73: Option Markets and Contracts

LOS

The candidate should be able to:

a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;

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Reference: An INtroduction to Derivatives and Risk Management by Don Chance

An option is a contract between two parties - a buyer and a seller- that gives the buyer the right, but not the obligation to purchase or sell something at a later date at a price agreed upon today.

the option buyer pays the seller the price or premium for the option that he is buying.

There are two types of basic options.

Call option:An option to buy is called a call.

Put option: An option to sell is called a put.

Options now trade in organized exchanges. But the creation of an organized options exchange was done in 1973 only. Prior to that options were bought and sold through dealers as contract between two parties. This type of market, called anover the counter market was actually the first type of options market.

Over the counter market is active now also and is used by corporations and financial institutions to enter into contracts tailor made for their requirements.

While options on OTC can have terms are convenient to the parties involved, exchange traded contract have various features standardized and prescribed by the exchange.

They are assets for which options are traded, contract size, exercise price, expiration date, position abd exercuse limits.

European option and American option,
European Call and American Call

European options can be exercised only on the termination date of the option. The buyer can demand delivery of the underlying asset or choose to allow the option (call) unexercised on the termination date. Till that termination date, he has no interaction with the option writer.

In the case of American option (call), the buyer can exercise the option on any day till the maturity day. The writer of seller of the option has to deliver on the day the buyer makes the demand for delivery.

Moneyness of an option

Moneyness is a relation between the current market price of the asset underlying an option contract.


In case of calls

If the current market price is equal to the exercise price the call is said to be at the money.
If the current market price is higher than the exercise price the call is said to be in the money.

If the current market price is lower than the exercise price the call is said to be out of the money.