2. Purpose
Provide a basic knowledge of the options market.
Introduce options terminology and mechanics.
Introduce the principles of option pricing.
3. What is an Option
An Option is a derivative instrument i.e. it’s value
depends on the value of an underlying asset.
The asset can be an equity or stock, a bond, a currency
or a commodity.
4. Option Trading
An Option can be traded:
- Over-the-counter (OTC): bilaterally negotiated
between the option seller (the writer or grantor) and
the option buyer (the holder).
- Exchange traded: traded on an exchange through a
3rd party (the clearing house) who matches buyer with
seller and assumes the credit risk of both parties.
5. Terminology
When buying an option, the option holder purchases the
right to buy or sell the underlying asset or commodity (the
underlying) at a specified price on or by a specified date.
An Option gives the holder the right to do something but
not the obligation.
If the Option holder decides to exercise the option, the
option writer is then obliged to carry out the underlying
transaction.
6. Option Types
Call Option: Gives the holder the right to buy the
underlying on or by a specified date and at a specified
price
Put Option: Gives the holder the right to sell the
underlying.
This terminology is generic and does not apply to all
Option types.
7. Contract
The contract that exists between the option writer and the
option holder contains the following:
- Option type: Call or Put Option.
- Strike or Exercise price: the price at which the holder has
the option to buy or sell the underlying.
- Maturity or Expiry date: the date on or by which the
option can be exercised.
- Option Style: e.g. American, European, Asian, Bermudan.
- Premium: Amount paid upfront by the option holder to
the writer to obtain the option.
