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CHAPTER 2 DEFINITIONS AN D TERMINOLOG Y 2.1 CaU s an d Puts 1 Very briefly, let us summarise th e definition s an d terminolog y tha t wil l be used in the following chapters. Ther e are two basic types of options: cal l options (o r simpl y calls) , an d pu t option s (o r puts) . A cal l optio n o n a n asset give s the owne r th e right t o buy th e asse t o n or before a certai n dat e at a certai n price . I f the righ t i s exercisable onl y o n tha t date , th e optio n is "European" : otherwis e i t i s a n "American " option . A pu t optio n give s the owne r th e righ t t o sel l a n asse t o n o r befor e a certai n date . Put s ca n also be Europea n o r America n i n nature. Th e pric e specified i n the optio n contract i s known a s the exercise price or strike price. Th e dat e specified i n the contrac t i s the exercis e date , expir y (expiration ) date , o r th e maturit y date o f the option . There ar e four type s o f participants i n options markets : buyers o f calls; sellers of calls; buyers o f puts; sellers of puts. Buyers ar e referre d t o a s havin g lon g position s an d seller s short positions . Selling a n optio n i s als o known a s writing it . An optio n confer s upo n th e holde r th e righ t bu t no t th e obligatio n t o buy o r sel l a n asse t a t a certai n pric e o n o r befor e a certai n date . Thi s fact distinguishe s option s fro m futures . Fo r example , th e holde r o f a lon g futures contrac t commit s himsel f t o buying an asse t a t a certai n pric e a t a certain dat e fro m now . I n contrast , th e holde r o f a Europea n cal l optio n has a right t o buy an asse t a t a certain price at a certain dat e in the future , but h e i s not contractuall y boun d t o exercise this right . 1 A classic exposition o f the properties, structur e an d tradin g procedures o f option s and optio n markets i s Cox & Rubinstein (1985) . A n excellent recen t surve y ca n b e foun d in Hul l (1997) . 6 Definitions and Terminology 2.2 Option s Tradin g To illustrate th e abov e concepts, suppose a n investor instructs his broker t o bu y on e Europea n cal l optio n o n Hongkon g Ban k stoc k wit h a n exercise price of $100 and a n exercise date of 31 July for $10 , and th e firm' s trader i s able to find anothe r trade r o n the floor willin g to sell a 31 July cal l option o n Hongkon g Ban k stoc k wit h a n exercis e pric e o f $100, for a pric e of $10. The most important piec e of information i n the contract i s the pric e the buye r i s willing to pa y for th e call , an d th e pric e a t whic h th e selle r i s willing t o writ e th e call . Onl y i f the tw o ar e th e sam e woul d th e dea l b e possible. (O n th e othe r hand , th e pric e of the stock a t th e tim e o f the dea l does not have to be equal to the exercise price: Hongkon g Bank shares ma y be tradin g a t $102 , greater tha n th e exercis e pric e of $100.) Th e sixty-fou r dollar...

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