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Sunday, June 03, 2001













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Option Basics - II

Anup Menon

LAST week we defined what an option is and talked about the two basic types of options namely calls and puts. We also saw the difference between an option writer and a buyer. This week we shall discuss some more key terms in options.

European Options: In India all options that are being introduced are of the European type. We can have a European put, call or any other advanced option variants. The question is what is the European Option. We know that an option holder has the right to exercise his option but not the obligation. The question is when can he exercise his right. Should it be on the maturity date or can he exercise it at any time after he has entered the contract. If the option can be exercised on the maturity date only, then the option is a European option.

American Options: The other type of option is known as the American Options. Most option contracts traded in developed markets are of the American type. The biggest advantage with the American Option is that it can be exercised by the holder at any point of time after entering the contract. However the question remains whether early exercise is optimal. Since the discussion of that topic is fairly academic, we shall deal with it on a later date.

Now that we have seen some of the basic types of options, let us look at some of the key valuation parameters that we should look for. The most important valuation parameter is volatility.

Measurement of volatility has been a subject for financial research, both academic and applied. This is all the more important in options since most positions tend to be leveraged and a wrong call on volatility can cost the trader a packet. The simplest and most widely used measure of volatility is the standard deviation. The standard deviation measures the deviation or changes in the return series from an average value. The higher the standard deviation, the more volatile the series.

However there have been many revised versions of volatility. For instance computation of the standard deviation assumes that the mean is unconditional. Modern volatility measurement techniques such as ARCH and its variants have been frequently referred to.

Next week we shall look into some of the other major valuation parameters such as exercise price and follow it up with a brief discussion on pricing models.

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