Page 68 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 6: Introduction to Options

10. American options: American options are options that can be exercised at any time upto the Notes
expiration date. Most exchange-traded options are American.
11. European options: European options are options that can be exercised only on the expiration
date itself. European options are easier to analyze than American options, and properties
of an American option are frequently deduced from those of its European counterpart.

12. Index options: These options have the index as the underlying. Some options are European
while others are American. Like index futures contracts, index options contracts are also
cash settled.
13. Stock options: Stock options are options on individual stocks. Options currently trade on
over 500 stocks in the United States. A contract gives the holder the right to buy or sell
shares at the specified price.
14. Option Premium: The "price" an option buyer pays and an option writer receives is known
as the premium. Premiums are arrived at through open competition between buyers and
sellers according to the rules of the exchange where the options are traded. A basic
knowledge of the factors that influence option premiums is important for anyone
considering options trading. The premium cost can significantly affect whether the investor
realize a profit or incur a loss.

Did u know? What is Option Premium?
The premium is the price at which an option trades, and is paid by the buyer to the writer
(seller) of the contract.

The premium paid by the buyer is non-refundable payment for the rights inherent in he
long contract. The writer (seller) of an option contract keeps the premium received, whether
assigned or not, and is in turn obligated to fulfill the short contract's obligations if
assignment is received. The two components of an option's total premium are intrinsic
value and time value.
15. Moneyness: In finance, moneyness is a measure of the degree to which a derivative is
likely to have positive monetary value at its expiration, in the risk-neutral measure.

Three are three positions in an options: In-the-money; At-the-money; and Out-of-the-
money.
(a) In-the-money option: An in-the-money (ITM) option is an option that would lead to a
positive cashflow to the holder if it were exercised immediately. A call option on
the index is said to be in-the-money when the current index stands at a level higher
than the strike price (i.e. spot price >strike price). If the index is much higher than the
strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the
index is below the strike price.
(b) Out-of-the-money option: An out-of-the-money (OTM) option is an option that would
lead to a negative cashflow if it were exercised immediately. A call option on the
index is out-of-the-money when the current index stands at a level which is less than
the strike price (i.e. spot price < strike price). If the index is much lower than the
strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the
index is above the strike price.

An out-of-the-money option currently has no intrinsic value -e.g. a call option is
out-the-money if the strike price ("the strike") is higher than the current underlying

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