[...]... in option theory and explain their practical interpretation The second is to show where option traders get their profit and how these commonly used terms relate to this profit The last objective is to show why companies and investors use options to satisfy their financial needs Chapter 1 OPTIONS 2 AN INTRODUCTION TO OPTIONS TRADING O ptions on stocks were first traded on an organized exchange in 1973 That... to analyze European options, because properties of American options can very often be deduced from its European counterpart Before an example is given, it is worthwhile to look at the boldface sentence in the de nition of an option The holder of an option is not obligated to exercise the option This means that at maturity the holder can decide not to do anything This is exactly why it is called an. .. to be traded Nowadays, options can be traded on many different exchanges throughout the world and on many different underlying assets These underlying assets include stocks, stock indices, currencies and commodities There are two general kinds of options, the call option and the put option A call option gives the holder the right, but not the obligation, to buy the underlying asset for a pre-specified... is always less than the price of its underlying stock, otherwise money could be made by buying the stock and shorting the call option So, for an investor planning to hold the underlying non-dividend paying stock longer than the term of the option, it would be cheaper to buy the call option for its intrinsic value than to actually buy the stock For that reason this particular investor, which must exist,... DIVIDENDS AND THEIR EFFECT ON OPTIONS 33 3.1 Forwards 34 3.2 Pricing of stock options including dividends 35 3.3 Pricing options in terms of the forward 36 3.4 Dividend risk for options 38 3.5 Synthetics 39 4 IMPLIED VOLATILITY 41 4.1 Example 44 4.2 Strategy and implied volatility 45 5 DELTA 47 5.1 Delta-hedging 52 5.2 The most dividend-sensitive options 57 5.3 Exercise-ready American calls on dividend... holder would not exercise his option right Because he would have to buy the stock for more than $50, and, under the conditions of the put options, sell the same stock for $50 This would mean he would always incur a loss So, if the stock price is more than $50, the holder does not exercise the option and faces a loss of $3, the 6 AN INTRODUCTION TO OPTIONS TRADING 50 40 Profit ($) 30 20 10 0 −3 −10 Stock... said to be a ‘European’ option If it can be exercised at any time up to expiration, the option is an ‘American’ option Although there are many other option types, the most important ones have already been covered: American call option, American put option, European call option and the European put option The vast majority of the options that are traded on exchanges are American However, it is useful to. .. after which the stock is sold immediately However, this stock has to be returned sometime For example, an investor shorts the stock Unilever for $50 Because the investor sells the stock Unilever he gets the $50 If after 1 year the stock price of Unilever is $40 he can decide to buy the stock on the market for $40 and return it to the party he borrowed it from With this strategy the investor makes a profit... option on a non-dividend paying stock early Because the price of a stock is an expectation of the future earnings there are always investors who want to hold the stock longer than the term of the option Even if such investors did not care about the option part, they would still be prepared to pay more for an American call option than its intrinsic value, since there is an interest rate advantage This... much as its European counterpart Although most options that are traded on exchanges are American, this book mainly focuses on European options Since American options are based on the same principles as European ones, and their properties can, very often, be easily derived from the European counterparts this is perfectly arguable Throughout this book, an option is assumed to be European, unless specifically . y0 w0 h0" alt="" AN INTRODUCTION TO OPTIONS TRADING Frans de Weert AN INTRODUCTION TO OPTIONS TRADING The Securities & Investment Institute Mission Statement: To set standards of professional. Martin Managing Director AN INTRODUCTION TO OPTIONS TRADING Frans de Weert Copyright # 2006 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone. British Library ISBN-13 97 8-0 -4 7 0-0 297 0-1 (PB) ISBN-10 0-4 7 0-0 297 0-6 (PB) Project management by Originator, Gt Yarmouth, Norfolk (typeset in 12/16pt Trump Mediaeval). Printed and bound in Great