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Study notes 1 - terminology and concepts about options

I am reading the book Design.Patterns.and.Derivatives.Pricing by Mark S. Joshi. Since I am from Computer science and electronic engineering background, I have difficulty in understanding some of the financial terminologies.

I had some basic financial accounting knowledge from university general electives and some stock trading experience, so I venture to do some self studying through internet searching.

On chapter 1, a simple Monte Carlo model. A simple Monte Carlo simulation requires five parameters input, (expiry, strike, spot, vol, r, and NumberOfPaths).

The wikipedia page (http://en.wikipedia.org/wiki/Call_option) provides a very nice introduction about call options.

1. What is an option?
A call option is a contract formed between 'caller' and 'writer'. The caller predicts that the stock price (spot price) will rise beyond an agreed limit (i.e., the strike price) on a defined future date (Expiry date), thus he pays a premium to the writer to enter into a contract which entitles him(the 'caller') the right to exercise the option by purchasing the underlying stock from the writer at the strike price on this defined future date.

The caller has the right to exercise the option at his discretion, and if he chooses to do so, the writer must agree to sell the stock.

In essence, the buyer is paying for a chance to buy a stock at certain price (hopefully a discounted price), rather than to buy the real stock.

In the above explanation, stock is used just for illustrative purpose; in real world, the underlying financial instrument could be different.

2. how does an option differs from warrant?

To my understanding, from a mathematics point of view, the key difference is that warrants are dilutive, which means the company has to issue new shares when the warrants are exercised. Options is only about changing ownership of the underlying financial instruments.

3. how much does the buyer earn or lose?
=>> if spot price is higher than the strike price, and yes, that is what the buyer (caller) expected, his earnings amounts to
S=P-(Q+R)
(S) Trader A's total earnings .
(P) Sale of stock at spot price
(Q) Amount paid to purchase the stock at strike price upon exerise
(R) Contract commissions (the premium paid)

==> or, if the spot price is lower than the strike price, obviously, it does not make sense for the buyer(caller) to exercise the option (paying higher than market price to purchase the stock), thus his total loss will be equal to -R.

4. what is 'in-the-money' and payoff?
When the spot price is higher than the strike price, the option is said to be 'in-the-money', which means the option has monetary value to the buyer(caller).

The earnings for the buyer(caller) resulting from exercising the option is called 'payoff'.
When the option is 'in-the-money', the payoff is (spot price - strike price). Otherwise, the payoff is zero.

5. what is over-the-counter instrument?
This is a bit side track. Warrants are often called over-the-counter instruments, which means it is normally traded between financial institutions without exchange facilities, as opposed to exchange trading (like you trade stock in HKSE or SGX).

6. what are European call option and American call option?

A European call option allows the holder to exercise the option (i.e., to buy) only on the option expiration date. An American call option allows exercise at any time during the life of the option.

7. Call option vs put option

What we have discussed above is termed call option; in layman terms, if the contract is modified to entitle the buyer to sell the underlying stock at certain price, then the option is termed put option. Here of course the buyer is taking a 'short' position towards the underlying instrument.



This post first appeared on Always Remember, You Are At Most Yourself; And, Yo, please read the originial post: here

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Study notes 1 - terminology and concepts about options

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