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OPTIONS

Options

Previously in the Futures chapter we learned about derivative instruments. As a reminder, derivatives are promise of delivery of certain amount of something (underlying product) by a certain date for a fixed price. Therefore derivatives by themselves do not constitute ownership of the underlying products, but a contract between the seller and the buyer where the seller delivers the product to the buyer for the specified price at the specified date on the contract. We also learned that futures are a type of derivative and the underlying products are commodities such as gold and corn, and financials such as currency or stock indices. At maturity the sellers of futures contracts are obligated to hold up their end of the bargain and make the delivery.

Meet another kind of derivative, the Option. Options work similarly to futures with one difference. The buyer of an option contract has the right to exercise it at any time up to the expiration date.

Well, this comes with a footnote. It applies to American style options, which allow the exercise of an option at anytime prior to its expiration date. Another kind of option is known as the European-style option, where the contracts are only exercisable on the expiration date (just like Futures contracts). However most options traded in options exchanges are American style and our discussion is also based on this assumption. With the American-style options the buyers are free to exercise the …