European Option

An option that can only be exercised at the end of its life

Bermuda Option
A type of option that can only be exercised on predetermined dates, usually every month
Exotic Option
A type of option that differs from common American or European options in terms of the
underlying asset or the calculation of how or when the investor receives a certain payoff. These
options are more complex than options that trade on an exchange, and generally trade over the
counter.
For example, one type of exotic option is known as a chooser option. This instrument allows an
investor to choose whether the options is a put or call at a certain point during the option's life.
Because this type of option can change over the holding period, it is apparent that this type of
option would not be found on a regular exchange, which is why it is classified as an exotic
option.
Other types of exotic options include: barrier options, Asian options, digital options and
compound options, among others.
Barrier Option
A type of option whose payoff depends on whether or not the underlying asset has reached or
exceeded a predetermined price.
A barrier option is a type of exotic option. It can be either a knock-in or a knock-out
Asian Option
An option whose payoff depends on the average price of the underlying asset over a certain
period of time as opposed to at maturity. Also known as an average option.
This type of option contract is attractive because it tends to cost less than regular American
options.
An Asian option can protect an investor from the volatility risk that comes with the market
Intrinsic Value
1. The actual value of a company or an asset based on an underlying perception of its true
value including all aspects of the business, in terms of both tangible and
intangible factors. This value may or may not be the same as the current market value.
Value investors use a variety of analytical techniques in order to estimate the intrinsic
value of securities in hopes of finding investments where the true value of the investment
exceeds its current market value.
2. For call options, this is the difference between the underlying stock's price and the strike
price. For put options, it is the difference between the strike price and the underlying
stock's price. In the case of both puts and calls, if the respective difference value is
negative, the instrinsic value is given as zero
3. 2. Intrinsic value in options is the in-the-money portion of the option's premium. For
example, If a call options strike price is $15 and the underlying stock's market price is at
$25, then the intrinsic value of the call option is $10. An option is usually never worth
less than what an option holder can receive if the option is exercised.

Time Value
The portion of the option premium that is attributable to the amount of time remaining until the
expiration of the option contract.
Basically, time value is the value the option has in addition to its intrinsic value
Exchange-Traded Option
An option traded on a regulated exchange where the terms of each option are standardized by the
exchange. The contract is standardized so that underlying asset, quantity, expiration date and
strike price are known in advance. Over-the-counter options are not traded on exchanges and
allow for the customization of the terms of the option contract.
Exchange-traded options are also known as "listed options

American Option
An option that can be exercised anytime during its life. The majority of exchange-traded options
are American.
Since investors have the freedom to exercise their American options at any point during the life of
the contract, they are more valuable than European options which can only be exercised at
maturity.
Consider this example: If you bought a Ford March Call option expiring in March of 2006 in
March 2005, you would have the right to exercise the call option at anytime up until its
expiration date. Had the Ford option been a European option, you could only exercise the option
at the expiry date in March '06. During the year, the share price could have been most optimal for
exercise in December of 2005, but you would have to wait to exercise your option until March
2006, where it could be out-of-the-money and virtually worthless.
Note that the name of this option style has nothing to do with the geographic location.

Online Appendix: Payoff Diagrams for Futures and Options

As we have seen, derivatives provide a set of future payoffs based on the price of
the underlying asset. We discussed how derivatives can be mixed and matched to create
synthetic financial instruments that mimic the behavior of more traditional financial
instruments. Payoff diagrams help to illustrate this concept. This appendix introduces
payoff diagrams and explains how to use them.
Futures Contract Payoffs
Recall that the buyer of a futures contract agrees to purchase a certain quantity of
a particular commodity or financial instrument at a prespecified price and time. The
seller of the futures contract promises to deliver the commodity or financial instrument
on the appointed date in return for payment at the settlement price. The value of these
promises (to the buyer) increases as the price of the underlying asset rises.

Figure 9A.1: Payoff from Buying a Futures Contract

Figure shows the payoff to holding the long position in a futures contract. As the price of the
underlying asset rises, the payoff to the buyer of the contract rises one-for-one. That is, a $1
increase in the price raises the payoff by $1.

Figure 9A.1 shows the payoff from buying a futures contract. As the price of the
underlying asset rises above the settlement price, the payoff to the futures contract buyer

goes up one for one ? a $1 dollar increase in the price of the underlying asset raises the
payoff to the long position by $1. As the price falls below the settlement price, the value
of the long position falls. In fact, the payoff from purchasing the underlying asset itself is
exactly the same as the payoff from buying a future, since arbitrage forces the futures
price to move with the price of the underlying asset. The crucial difference is that, in
buying a futures contract, all the buyer needs to do is post margin. While buying a
futures contract is substantially cheaper than buying the underlying asset, it means
accepting greater risk.

Figure 9A.2: Payoff from Selling a Futures Contract

Figure shows the payoff to holding the short position in a futures contract. As
the price of the underlying asset rises, the payoff to the seller of the contract
falls one-for-one. That is, a $1 increase in the price reduces the payoff by $1.

The payoff from selling a futures contract, or taking the short position, is shown
in Figure 9A.2. This mirror image of Figure 9A.1 shows that the buyer?s gains are the
seller?s losses, and vice versa. Again, the payoff to the short position rises and falls
one-for-one with the price of the underlying asset ? a $1 increase in the price of the
underlying asset reduces the payoff to the seller by $1, while a $1 fall in the price raises
the payoff by $1.
Options Payoffs
There are four ways to invest in options: buying and selling either a put or a call. We
will begin with the buying of a call option. Remember that buying an option creates
rights but not obligations. Because the buyer need not exercise the option, the loss from

owning it cannot exceed the price paid for it. So long as the price of the underlying asset
is below the strike price of the call, the holder will not exercise the option, and will lose
the premium initially paid for it. This means that the payoff function is flat, beginning at
an underlying asset price of zero and continuing to the strike price, with a loss equal to
the call premium. As the price of the underlying asset rises beyond the strike price, the
call comes into the money, and the payoff begins to rise one for one with the price of the
underlying asset (see Figure 9A.3).

Figure 9A.3: Payoff from Buying a Call Option

The buyers of a call option pays a premium, and then receives a payoff that
rises one-for-one with the price of the underlying asset once the price rises
above the strike price of the option.

What benefits the call buyer costs the call writer. So long as the underlying asset price
remains below the strike price of the call, the writer pockets the premium, and the payoff
is positive. But when the underlying asset price rises above the strike price, the writer
begins to suffer a loss. The higher the price climbs, the more the call writer loses, as
Figure 9A.4 shows.

Figure 9A.4: Payoff from Writing a Call Option

The payoff to writing a call option is exactly the opposite of the payoff to
buying one. The writer receives the call-option premium so long as the price of
the underlying asset remains below the strike price of the call. Once the

underlying asset?s price rises above the strike price, the payoff to option writer
falls one-for-one with the price of the underlying asset.

Figure 9A.5: Payoff from Buying a Put Option

The buyer of a put option pays a premium, and then receives a payoff that
starts to rise once the price of the underlying asset falls below the strike price
of the option. The payoff rises $1 for each dollar that the price of the falls
below the strike price.

Turning to puts, we can use the same simple process to draw their payoff
diagrams. The buyer of a put purchases the right to sell a stock at the strike price. Puts
have value only when the price of the underlying asset is below the strike price. The
payoff is highest when the price of the underlying asset is lowest. As the asset?s price
rises, the payoff falls, though it cannot go below the premium paid for the put (see
Figure 9A.5)

Figure 9A.6: Payoff from Writing a Put Option

The payoff to writing a put option is exactly the opposite of the payoff to
buying one. The writer receives the put-option premium so long as the price of
the underlying asset remains above the strike price of the put. Once the

underlying asset?s price falls below the strike price, the payoff to option writer
falls one-for-one as the price of the underlying asset falls.

Writing a put is the reverse of buying one. Again, the writer loses when the
holder gains, so the maximum payoff is the premium. The best outcome for an option
writer is to have the option expire worthless, so that it is never exercised. Looking at
Figure 9A.6, we can see that the put writer?s losses are highest when the price of the
underlying asset is lowest; it declines as the price rises. So long as the asset price
exceeds the strike price, the put writer?s payoff equals the premium charged to write the
put. In this chapter, we learned that buying and selling options and futures in various
combinations can be planned to create customized risks. Two examples were given. The
first was the use of options to replicate the payoff pattern of a futures contract. Buying a
futures contract is equivalent to purchasing a call and selling a put, both of which are at
the money and have the same expiration date as the futures contract (see page 000 ?
cross-reference to p.9.17). Notice how putting Figure 9A.3 on top of Figure 9A.6 makes
the combined payoff a continuous upward sloping line.
The second example was the use of options to bet that a stock?s price would move
significantly, either up or down (see page 000 ? p.9.18). Looking at the payoff diagrams,
we see that buying a call yields a payoff when the price rises (see Figure 9A.3), while
buying a put yields a payoff when the price falls (see Figure 9A.5). By putting the two
together, an investor creates a financial instrument that loses falls in value when prices
are stable (the premium is lost when the price stays the same), but rises in value when
prices are highly volatile. [1302]

Futures or option contract

What is the difference between a futures contract and an option?
A futures contract is a legally binding agreement to buy or sell an asset on a specified
future date. Both buyers and sellers have significant exposure should the market move
against them.
The buyer of an option contract has the right, but no obligation, either to buy or to sell
the underlying asset. Therefore the option buyer's maximum possible loss is limited to
the premium paid.
Other differences include no exercise price for a futures contract and no premium
payable when trading a futures contract.