Options on stocks were first traded on an organized exchange in 1973. That very same year Black and Scholes introduced their famous Black-Scholes formula. This formula gives the price of an option in terms of its parameters, like the underlying asset, time to maturity and interest rate. The formula and the variables it depends on will be discussed in more detail in the next chapters. Since 1973 option markets have grown rapidly, not only in volumes but also in the range of option products to be traded. Nowadays, options can be traded on many different exchanges throughout the world and on many different underlying assets. These underlying assets include stocks, stock indices, currencies and commodities.
There are two general kinds of options, the call option and the put option. A call option gives the holder the right, but not the obligation, to buy the underlying asset for a pre-specified price and at a pre-specified date. A put option gives the holder the right, but not the obligation, to sell the underlying asset for a pre-specified price and at a pre-specified date. This pre-specified price is called the ‘strike price’; the date is known as the ’expiration date’, or ‘maturity’. The underlying asset in the definition of an option can be virtually anything, like potatoes, the weather, or stocks. Throughout this book the underlying asset will be taken to be a stock.
When the owner of a call option chooses to buy the stock, it is said that he exercises his ...