Options High School
In practice, one can calculate the Black—Scholes price of a European option that is equivalent to the American option except for the exercise dates of course. Therefore, you should consider which vehicle offers the best opportunity in terms of option liquidity and bid-ask spreads.
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In finance, the style or family of an option is the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American style options. These options—as well as others where the payoff is calculated similarly—are referred to as " vanilla options ".
Options where the payoff is calculated differently are categorized as " exotic options ". Exotic options can pose challenging problems in valuation and hedging. The key difference between American and European options relates to when the options can be exercised:. Where K is the strike price and S is the spot price of the underlying asset. Option contracts traded on futures exchanges are mainly American-style, whereas those traded over-the-counter are mainly European.
Nearly all stock and equity options are American options, while indexes are generally represented by European options. Commodity options can be either style. Traditional monthly American options expire the third Saturday of every month. They are closed for trading the Friday prior.
First came options on stock index futures, then options on indexes, which could be traded in stock accounts. Next came index funds, which allowed investors to buy and hold a specific stock index. The latest burst of growth began with the advent of the exchange-traded fund ETF and has been followed by the listing of options for trading against a wide swath of these new ETFs. The Lowdown On Index Funds. An Overview of Index Trading A market "index" is simply a measure designed to allow investors to track the overall performance of a given combination of investment instruments.
While such market indexes track the "big picture" of price trends, the fact is that for most of the 20th century the average investor had no avenue available to actually trade these indexes. With the advent of index trading, index funds and index options that threshold was finally crossed.
Other families including Guggenheim Funds and ProFunds took things to an even higher level by rolling out, over time, a wide variety of long, short and leveraged index funds. The Advent of Index Options The next area of expansion was in the area of options on various indexes. The listing of options on various market indexes allowed many traders for the first time to trade a broad segment of the financial market with one transaction.
A partial listing of some the more actively traded index options appears in Figure 1. The first thing to note about index options is that there is no trading going on in the underlying index itself. It is a calculated value and exists only on paper. The options only allow one to speculate on the price direction of the underlying index, or to hedge all or some part of a portfolio that might correlate closely to that particular index.
As a result, anytime during the trading day an investor can buy or sell an ETF that represents or tracks a given segment of the markets. The vast proliferation of ETFs has been another breakthrough that has greatly expanded the ability of investors to take advantage of many unique opportunities.