Analysis of Asset Allocation

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Options: An introduction
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DEFINITION

A put (call) option is the contract right to sell (buy) a specified amount of asset (real or financial) at a fixed price on or before a fixed date.

Every discipline has its own special vocabulary. It is also the case with options. To avoid needless repetition, we will define them now.

Terminology.

  • The fixed price is called strike price.

  • The fixed date is called expiry or expiration date.

  • The asset is called the underlying.

  • When the holder (investor) acts upon his right to buy (call) or sell (put), he (or she) exercises the option.

  • When the option buyer exercises, the seller is assigned.

  • The price paid for the option is called the premium.

As we have options that can exercised at or before a fixed date, we have two major styles:

  • American style: the option can be exercised at any time before the expiry date.
  • European style: the option can be exercised only at the expiry date and not before.

Note that the style has nothing to do with the location of the stock exchange. We have European style options traded on the US market and American style options traded in Europe.

As an option has a value (premium), we will analyze in the next topic the basic components of the option's price.

 

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