American v/s European options

Let not the name deceive you. The naive may conclude that ‘American options’ trade in America and the ‘European’ in Europe. However, that’s not the case. The name implies the type of option rather than the geography!!

American options allow the holder of the option to exercise the option at any point before expiry. On the other hand European options can be exercised only at option expiry. Thus the two kinds of options differ because an American option allows the user and early exercise. Most of the options that you see in the market today are American options.

Value wise, at expiration, an American and a European option will have the same value. However, prior to expiration these 2 options are conceptually different. Consider 2 options, one American and one European, having the same underlying, the same exercise price and the same time until expiration. The American option provides the owner, all the rights and privileges the owner of the European option possesses. In addition, the holder of an American option can execute the option before expiration. Hence, at any point of time before expiration, an American option is at least as valuable as a similar European option.

Refer to the book ‘Understanding Options’ by ‘Robert W.Kolb’ for more options!!

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Naked Calls !!

While reading the book ‘Understanding Options’ by ‘Robert W Kolb’ i came across this term ‘naked calls’!! Having never heard of the term before it was pretty interesting to read about it. For the uninitiated read ahead.

To start off let me talk about call options. A call option represents a right to buy. The owner of a call option has the right to purchase the stock at a pre-specified price. This right lasts with the owner/buyer till the option expires. The other party to the option is the option seller/writer. The option writer is obligated to sell the stock when the option buyer decides to execute his option. If the call writer owns the underlying stock then the option is a ‘covered call’.

Now, it need not always be necessary that one holds the stocks when he/she writes a call option. For e.g. if the writer could write a call option on stock ABC without holding the stock ABC. The option in this case would be deemed as an ‘Uncovered’ or ‘Naked’ call. In case of a naked call , the writer/seller undertakes the obligation of immediately securing the underlying stock and delivering it if the holder/buyer of the call option decides to execute the call option.

Interesting !!

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