The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

LISTED EQUITY OPTIONS

Equity derivative products are either exchange-traded listed derivatives or OTC derivatives. In this section we will look at listed equity options .²⁴²

An option is a contract in which the option seller grants the option buyer the right to enter into a transaction with the seller to either buy or sell an underlying asset at a specified price on or before a specified date. The specified price is called the strike price or exercise price and the specified date is called the expiration date. The option seller grants this right in exchange for a certain amount of money called the option premium or option price.

The option seller is also known as the option writer, while the option buyer is the option holder. The asset that is the subject of the option is called the underlying. The underlying can be an individual stock, a basket of stocks, a stock index or group of indexes, or another derivative instrument such as a futures contract or an ETF. The option writer can grant the option holder one of two rights. If the right is to purchase the underlying, the option is a call option. If the right is to sell the underlying, the option is a put option.

An option can also be categorized according to when it may be exercised by the buyer. This is referred to as the exercise style. A European option can only be exercised at the expiration date of the contract. An American option can be exercised any time on or before the expiration date. A Bermudan option is in between ...