derivatives

pradeeppdy
Finance Junkie
Posts: 258
Joined: Thu Sep 20, 2012 3:42 pm

derivatives

Postby pradeeppdy » Mon Oct 15, 2012 12:05 am

I am not clear with american option vs european option,i understand the concept of early termination(American) and termination at expiry of option(European).
And why american call is not benificial for us in terms of early termination, but american put gives you additional benefit?

Please explian these terms with examples if you can.

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pankaj
Finance Junkie
Posts: 61
Joined: Fri Aug 03, 2012 11:24 am

Re: derivatives

Postby pankaj » Tue Oct 16, 2012 4:58 pm

The two reasons why american call is not beneficial in terms of early termination are....
1) Loss of insurance: Because options act as insurance, if you exercise call option prior to maturity and buy the underlying stock, you lose the protection in case market price went down in the remaining period of the contract. That is if you had not exercised the option before maturity, you could have let the call option expire, in case securities are available in the market for less than the exercise price.
For example: Suppose you purchase a 3 months call option with the exercise price of $50 to buy XYZ securities. Now, say 1 month has passed and the current market price of the XYZ securities is $53. Because the option is in the money, you decided to exercise the call option to purchase the underlying securities at the exercise price($50).

Now, say after one week of your purchase of securities, the share price of XYZ securities went down, say its $30. In this case, you cannot use call option as you have already utilized the option at the time of small price hike.

2)Loss of Interest: In case of early exercise, you are using your funds(money) earlier than that could be used at the option expiry date. And because of early utilization of funds you are loosing interest income (if its our own fund) which could be earned on those funds or if you have borrowed the funds to buy the underlying securities, you are unnecessarily paying interest for the remaining period of the option.

pradeeppdy
Finance Junkie
Posts: 258
Joined: Thu Sep 20, 2012 3:42 pm

Re: derivatives

Postby pradeeppdy » Thu Oct 18, 2012 9:28 pm

Thanks Pankaj,

I agree with you,if price of stock suddenly went down i lose 20 as per your example.
and if i have american put option and i will exercise it prior to its maturity and after that suddenly the prices of stock went up high then its also a loss of insurance,but the puts are beneficial for us when we excercise them prior to expiration.

Regards


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