Lecture 2 Flashcards
what is an option?
An option is a derivative contract between two parties for a future transaction on an asset at a specified reference price.
The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfil the transaction.
With a future or forward were setting a fair price today to trade at some point in the future and if the market moves up and down there will be wins and losses based upon that.
With an option, very similar in that were setting the price today to trade
at some point in the future, but the big difference here is that one of the two parties is able to say whether the transaction goes ahead or not. they are able to either cancel the transaction or go ahead.
this means that one side of the contract is in a better position than the other party to the contract.
The way it’s made even or fair is that one of the two parties, the buyer of the option has to pay the seller a fee (an options premium) to get them to agree to enter this transaction with them
Options cost money at inception while Futures cost nothing at inception.
Types of options
Call Options:
The buyer of a call option has the right, but not the obligation to buy an agreed quantity of a particular underlying from the seller of the option at a certain time, the expiration, for a certain price, the strike.
The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide.
The buyer pays a fee (called a premium) for this right.
Put Options:
The buyer of a put option, has the right, but not the obligation, to sell the asset at the strike price by the future date.
The seller (or “writer”) has the obligation to buy the asset at the strike price if the buyer exercises the option.
The buyer pays a fee (called a premium) for this right.
American and European options
American Options may be exercised at any time up to and including the contract’s expiration date.
European Options can be exercised only on the contract’s expiration date.
American Options are most commonly traded, while European Options are easiest to price
