Unit 9 GlossaryAMERICAN OPTION: It isan option that can be exercised anytime during its life. The majority of exchange-traded options are American. Since investors have the freedom to exercise their American options at any point during the life of the contract, they are more valuable than European options which can only be exercised at maturity. ASIAN OPTION: It is an option whose payoff depends on the average price of the underlying asset over a certain period of time as opposed to at maturity. Also known as an average option. This type of option contract is attractive because it tends to cost less than regular American options. An Asian option can protect an investor from the volatility risk that comes with the market.
AT THE MONEY: It means an option that is at-the-money if the strike price of the option equals the market price of the underlying security. AVERAGE STRIKE OPTION: Itis atype of stock option used on Asian exchanges. The strike price in this type of option is based on the average asset price during a certain period of time, defined by a range of dates called the "fixings." This type of option is less volatile than traditional options, which have a predetermined strike price. BARRIER OPTION: It is a type of option whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price. A barrier option is a type of exotic option. It can be either a knock-in or a knock-out.
BASIS RATE SWAP: It is a type of swap in which two parties swap variable interest rates based on different money markets. This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates. For example, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury Bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the T-Bill rate for the LIBOR rate, they eliminate this interest-rate risk.
BENCHMARK: It is a standard against which the performance of a security, mutual fund or investment manager can be measured. Generally, broad market and market-segment stock and bond indexes are used for this purpose. When evaluating the performance of any investment, it's important to compare it against an appropriate benchmark. In the financial field, there are dozens of indexes that analysts use to gauge the performance of any given investment including the S&P 500, the Dow Jones Industrial Average, the Russell 2000 Index and even competitor fund.
BERMUDA OPTION: It is a type of option that can only be exercised on predetermined dates, usually every month. Like the mixed culture of Bermuda, bermuda options are a combination of American and European style options.
BOND SWAP: It is a strategy in which an investor sells a bond and at the same time purchases a different bond with the proceeds from the sale. There are several reasons why people use a bond swap: to seek tax benefits, to change investment objectives, to upgrade a portfolio's credit quality or to speculate on the performance of a particular bond. CALL OPTION: It is an agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period. It may help you to remember that a call option gives you the right to "call in" (buy) an asset. You profit on a call when the underlying asset increases in price. CLEARING: It is the procedure by which an organization acts as an intermediary and assumes the role of a buyer and seller for transactions in order to reconcile orders between transacting parties. Clearing is necessary for the matching of all buy and sell orders in the market. It provides smoother and more efficient markets, as parties can make transfers to the clearing corporation, rather than to each individual party with whom they have transacted. CLEARING HOUSE: It is an agency or separate corporation of a futures exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery and reporting trading data. Clearing houses act as third parties to all futures and options contracts - as a buyer to every clearing member seller and a seller to every clearing member buyer. Each futures exchange has its own clearing house. All members of an exchange are required to clear their trades through the clearing house at the end of each trading session and to deposit with the clearing house a sum of money (based on clearing house margin requirements) sufficient to cover the member's debit balance. COMMODITY SWAP: It is a swap in which exchanged cash flows are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodity. The vast majority of commodity swaps involve oil. So, for example, a company that uses a lot of oil might use a commodity swap to secure a maximum price for oil. In return, the company receives payments based on the market price (usually an oil price index). On the other side, if a producer of oil wishes to fix its income, it would agree to pay the market price to a financial institution in return for receiving fixed payments for the commodity. CONVERTIBLES: They are securities, usually bonds or preferred shares, that can be converted into common stock. Convertibles are ideal for investors demanding greater potential for appreciation than bonds provide and higher income than common stocks offer. CREDIT DERIVATIVES: They are privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments). For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.
CREST: It is Crest Co Ltd. is the central securities depository for the U.K. markets and Irish stocks. More specifically, Crest operates an electronic settlement system, which was established in 1996 and is used to settle a vast number of international securities. The company can also physically hold stock certificates on the behalf of customers. By holding securities as well as maintaining an electronic clearing system, Crest can provide for same-day clearing of securities transactions if needed. Its overall ability to provide a fast transfer of title for the securities it handles is its most important advantage to investors.
CURRENCY SWAP: It is a swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet. For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. Currency swaps were originally done to get around exchange controls.
DEEP IN THE MONEY: It means an option with an exercise price, or strike price, significantly below (for a call option) or above (for a put option) the market price of the underlying asset. Significantly, below/above is considered one strike price below/above the market price of the underlying asset. For example, if the current price of the underlying stock was $10, a call option with a strike price of $5 would be considered deep in the money.
DEEP OUT OF THE MONEY: It means an option with a strike price that is significantly above (for a call option) or below (for a put option) the market price of the underlying asset. To be deemed deep out of the money, an option's strike price should be at least one strike price below/above the market price of the underlying asset's option chain.
DERIVATIVE: It is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.
DOWN-AND-OUT BARRIER OPTION: It is a type of barrier option in which the spot price of the underlying is set above the barrier level, and the price of the underlying must close lower in order for the option to be knocked out or cancelled. It is named "down-and-out" because the right to exercise the option disappears if the price of the underlying is below the barrier. EUROPEAN OPTION: It is an option that can only be exercised at the end of its life, at its maturity. European options tend to sometimes trade at a discount to its comparable American option. This is because American options allow investors more opportunities to exercise the contract. EXOTIC OPTION: It is an option that differs from common American or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. These options are more complex than options that trade on an exchange, and generally trade over the counter. DELIVERY DATE: It is 1. The final date by which the underlying commodity for a futures contract must be delivered in order for the terms of the contract to be fulfilled. 2. The maturity date of a currency forward contract. All futures and forward contracts have a delivery date upon which the underlying must be transferred to the contract holder if he or she holds the contract until maturity instead of offsetting it.
DOW JONES INDUSTRIAL AVERAGE: It is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The DJIA was invented by Charles Dow back in 1896. Often referred to as "the Dow", the DJIA is the oldest and single most watched index in the world. The DJIA includes companies like General Electric, Disney, Exxon and Microsoft. When the TV networks say "the market is up today", they are generally referring to the Dow. DOW JONES 65 COMPOSITE AVERAGE: It is a composite index that measures changes within the 65 companies that make up three Dow Jones averages: the 30 stocks that form the Dow Jones Industrial Average (DJIA), the 20 stocks that make up the Dow Jones Transportation Average (DJTA) and the 15 stocks of the Dow Jones Utility Average (DJUA). The Dow Jones 65 Composite, like the three sub-indexes, is price-weighted. All of the Dow Jones averages are price-weighted indexes. For this type of index, stocks with higher prices will influence the direction of the average more than lower prices, regardless of the actual size of the company. Most broad market indexes are market-cap weighted, such as the Nasdaq-100 and Standard & Poor's 500. EXPIRATION DATE: It is the day on which an options or futures contract is no longer valid and, therefore, ceases to exist. The expiration date for all listed stock options in the U.S. is the third Friday of the expiration month (except when it falls on a holiday, in which case it is on Thursday).
FINANCIAL ENGINEERING: It is a multidisciplinary field relating to the creation of new financial instruments and strategies, typically exotic options and specialized interest rate derivatives. Financial engineering is also the process of creating new securities or processes, and designing new financial instruments, especially derivative securities. More importantly financial engineering is the process of employing mathematical, finance and computer modeling skills to make pricing, hedging, trading and portfolio management decisions. Utilizing various derivative securities and other methods, financial engineering aims to precisely control the financial risk that an entity takes on. Methods can be employed to take on unlimited risks under certain events, or completely eliminate other risks by utilizing combinations of derivative and other securities. Notable financial engineers include F. Black and M. Scholes for the pricing of options and corporate liabilities, Robert C. Merton for his theory of rational option pricing and the introduction of stochastic calculus in the study of finance. Robert F. Engle is also notable for the work in analyzing economic time-series with time-varying volatility. Clive W. J. Granger analyzed the economic time series with common trend.
FIXED-FOR-FIXED SWAP: It is an arrangement between two parties (known as counterparties) in which both parties pay a fixed interest rate that they could not otherwise obtain outside of a swap arrangement. To understand how investors benefit from these types of arrangements, consider a situation in which each party has a comparative advantage to take out a loan at a certain rate and currency. For example, an American firm can take out a loan in the United States at a 7% interest rate, but requires a loan in yen to finance an expansion project in Japan, where the interest rate is 10%. At the same time, a Japanese firm wishes to finance an expansion project in the U.S., but the interest rate is 12%, compared to the 9% interest rate in Japan. Each party can benefit from the other's interest rate through a fixed-for-fixed currency swap. In this case, the U.S. firm can borrow U.S. dollars for 7%, then lend the funds to the Japanese firm at 7%. The Japanese firm can borrow Japanese yen at 9%, then lend the funds to the U.S. firm for the same amount.
FIXED-FOR-FLOATING SWAP: It is an advantageous arrangement between two parties (counterparties), in which one party pays a fixed rate, while the other pays a floating rate. To understand how each party would benefit from this type of arrangement, consider a situation where each party has a comparative advantage to take out a loan at a certain rate and currency. For example, Company A can take out a loan with a one-year term in the U.S. for a fixed rate of 8% and a floating rate of Libor + 1% (which is comparatively cheaper, but they would prefer a fixed rate). On the other hand, Company B can obtain a loan on a one-year term for a fixed rate of 6%, or a floating rate of Libor +3%, consequently, they'd prefer a floating rate. Through an interest rate swap, each party can swap its interest rate with the other to obtain its preferred interest rate. Note that swap transactions are often facilitated by a swap dealer, who will act as the required counterparty for a fee.
FORWARD CONTRACT: It is a cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. Most forward contracts don't have standards and aren't traded on exchanges. A farmer would use a forward contract to "lock-in" a price for his grain for the upcoming fall harvest.
FRONT FEE: It is an amount paid for initiating a compound or split-fee option contract. While all option contracts require a fee (the option premium) to be paid up-front to the seller, only compound or split-fee options require another amount (the back fee) for exercising them. FUTURES CONTRACT: It is a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. HEDGE: It is making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).
INDEX: It is a statistical measure of change in an economy or a securities market. In the case of financial markets, an index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value. Stock and bond market indexes are used to construct index mutual funds and exchange-traded funds (ETFs) whose portfolios mirror the components of the index.
INDEX OPTION: It is a call or put option on a financial index. Investors trading index options are essentially betting on the overall movement of the stock market as represented by a basket of stocks. Options on the S&P 500 are some of the most actively traded options in the world.
INDEX FUTURES CONTRACT: It is a futures contract on a stock or financial index. For each index there may be a different multiple for determining the price of the futures contract. For example, the S&P 500 Index is one of the most widely traded index futures contracts in the U.S. Stock portfolio managers who want to hedge risk over a certain period of time often use S&P 500 futures to do so. By shorting these contracts, stock portfolio managers can protect themselves from the downside price risk of the broader market. However, by using this hedging strategy, if perfectly done, the manager's portfolio will not participate in any gains on the index; instead, the portfolio will lock in gains equivalent to the risk-free rate of interest.
INTEREST RATE SWAP: It is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap. Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate specifications) for another. Because they trade OTC, they are really just contracts set up between two or more parties, and thus can be customized in any number of ways. Generally speaking, swaps are sought by firms that desire a type of interest rate structure that another firm can provide less expensively. For example, let's say Cory's Tequila Company (CTC) is seeking to loan funds at a fixed interest rate, but Tom's Sports Inc. (TSI) has access to marginally cheaper fixed-rate funds. Tom's Sports can issue debt to investors at its low fixed rate and then trade the fixed-rate cash flow obligations to CTC for floating-rate obligations issued by TSI. Even though TSI may have a higher floating rate than CTC, by swapping the interest structures they are best able to obtain, their combined costs are decreased - a benefit that can be shared by both parties.
IN THE MONEY: It means 1. For a call option, when the option's strike price is below the market price of the underlying asset. 2. For a put option, when the strike price is above the market price of the underlying asset. Being in the money does not mean you will profit, it just means the option is worth exercising. This is because the option costs money to buy. KNOCK-IN OPTION: It is a latent option contract that begins to function as a normal option ("knocks in") only once a certain price level is reached before expiration. KNOCK-OUT OPTION: It is an option with a built in mechanism to expire worthless should a specified price level be exceeded. LONDON INTERBANK OFFERRED RATE – LIBOR: It is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year. The LIBOR is the world's most widely used benchmark for short-term interest rates. It's important because it is the rate at which the world's most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus four or five points. Countries that rely on the LIBOR for a reference rate include the United States, Canada, Switzerland and the U.K.
LONG POSITION: It is 1. The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value. 2. In the context of options, the buying of an options contract. Opposite of "short" (or short position).
MARGIN ACCOUNT: It is a brokerage account in which the broker lends the customer cash to purchase securities. The loan in the account is collateralized by the securities and cash. If the value of the stock drops sufficiently, the account holder will be required to deposit more cash or sell a portion of the stock. In a margin account, you are investing with your broker's money. By using leverage in such a way, you magnify both gains and losses.
NEAR THE MONEY: It means an options contract where the strike price is close to the current market price of the corresponding underlying security. An options contract is said to be near the money when the strike price and underlying security’s price are close; it is at the money when the strike price is equal to the market price of the underlying security. At or near the money options contract typically cost more (i.e. there will be a higher premium) than out of the money options, where the underlying instrument’s price is far away from the strike price. Also called close to the money. OFFSET: It means 1. To liquidate a futures position by entering an equivalent, but opposite, transaction which eliminates the delivery obligation. 2. To reduce an investor's net position in an investment to zero, so that no further gains or losses will be experienced from that position. 1. Investors will offset futures contracts and other investment positions in order to remove themselves from any associated liabilities. Almost all futures positions are offset before the terms of the futures contract are realized. Despite the fact that most positions are offset near the delivery term, the benefits of the futures contract as a hedging mechanism are still realized. 2. If the initial investment was a purchase, a sale is made to neutralize the position; to offset an initial sale, a purchase is made to neutralize the position. For example, if you wanted to offset a long position in a stock, you could short sell an identical number of shares. By doing so, your net ownership of the stock would be zero, and you would not incur any further gains or losses from the position. OPTION: It is a financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date). Call options give the option to buy at certain price, so the buyer would want the stock to go up. Put options give the option to sell at a certain price, so the buyer would want the stock to go down. Options are extremely versatile securities that can be used in many different ways. Traders use options to speculate, which is a relatively risky practice, while hedgers use options to reduce the risk of holding an asset. OUT OF THE MONEY: It means 1. For a call, when an option's strike price is higher than the market price of the underlying asset. 2. For a put, when the strike price is below the market price of the underlying asset. PLAIN VANILLA: It is the most basic or standard version of a financial instrument, usually options, bonds, futures and swaps. Plain vanilla is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, resulting in a more complex security. For example, a plain vanilla option is the standard type of option, one with a simple expiration date and strike price and no additional features. With an exotic option, such as a knock-in option, an additional contingency is added so that the option only becomes active once the underlying stock hits a set price point. PREMIUM: It can be 1. The total cost of an option. 2. The difference between the higher price paid for a fixed-income security and the security's face amount at issue. 3. The specified amount of payment required periodically by an insurer to provide coverage under a given insurance plan for a defined period of time. The premium is paid by the insured party to the insurer, and primarily compensates the insurer for bearing the risk of a payout should the insurance agreement's coverage be required. PRICE-WEIGHTED INDEX: It is a stock index in which each stock influences the index in proportion to its price per share. The value of the index is generated by adding the prices of each of the stocks in the index and dividing them by the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index. For example, assume that an index contains only two stocks, one priced at $1 and one priced at $10. The $10 stock is weighted nine times higher than the $1 stock. Overall, this means that this index is composed of 90% of the $10 stocks and 10% of $1 stock. In this case, a change in the value of the $1 stock will not affect the index's value by a large amount, because it makes up such a small percentage of the index. A popular price-weighted stock market index is the Dow Jones Industrial Average. It includes a price-weighted average of 30 actively traded blue chip stocks.
PUT OPTION: It is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares. A put becomes more valuable as the price of the underlying stock depreciates relative to the strike price.
RUSSELL 2000 INDEX: It is an index measuring the performance of the 2,000 smallest companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small cap stocks in the United States. The weighted average market capitalization for companies in the Russell 2000 is about US$1 billion and the index itself is considered to be the benchmark for all small cap mutual funds.
RUSSELL 2500 INDEX: It is a broad index featuring 2,500 stocks that cover the small and mid cap market capitalizations. The Russell 2500 is a market cap weighted index that includes the smallest 2,500 companies covered in the Russell 3000 universe of United States-based listed equities.
RUSSELL 3000 INDEX: It is a market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of the entire U.S. stock market. More specifically, this index encompasses the 3,000 largest U.S.-traded stocks, in which the underlying companies are all incorporated in the U.S.
SHORT POSITION: It can be 1. A sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value. 2. In the context of options, it is the sale (also known as "writing") of an options contract. It is the opposite of "long (or long position)".
SPECULATION IN OPTIONS: In terms of speculation, option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security. For example, because the option writer will need to provide the underlying shares in the event that the stock's market price will exceed the strike, an option writer that sells a call option believes that the underlying stock's price will drop relative to the option's strike price during the life of the option, as that is how he or she will reap maximum profit. This is exactly the opposite outlook of the option buyer. The buyer believes that the underlying stock will rise, because if this happens, the buyer will be able to acquire the stock for a lower price and then sell it for a profit.
STANDARD & POOR’S 500: It is one of the world's best known indexes, and is the most commonly used benchmark for the stock market. Other prominent indexes include the DJ Wilshire 5000 (total stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, Far East) and the Lehman Brothers Aggregate Bond Index (total bond market). Because, technically, you can't actually invest in an index, index mutual funds and exchange-traded funds (based on indexes) allow investors to invest in securities representing broad market segments and/or the total market.
STOCK OPTION: It is a privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date. In the U.K., it is known as a "share option".
STRIKE PRICE: It is the price at which a specific derivative contract can be exercised. Strike price is mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold. The difference between the underlying security's current market price and the option's strike price represents the amount of profit per share gained upon the exercise or the sale of the option. This is true for options that are in the money; the maximum amount that can be lost is the premium paid. Also known as the "exercise price". Strike prices are one of the key determinants of the premium, which represents the market value of an options contract. Other determinants include the time until expiration, the volatility of the underlying security and prevailing interest rates. Strike prices are established when a contract is first written. Most strike prices are in increments of $2.50 and $5.
SWAP: It is traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps. SWAPTION: It is the option to enter into an interest rate swap. In exchange for an option premium, the buyer gains the right but not the obligation to enter into a specified swap agreement with the issuer on a specified future date. The agreement will specify whether the buyer of the swaption will be a fixed-rate receiver (like a call option on a bond) or a fixed-rate payer (like a put option on a bond).
UNDERLYING ASSET: It is a term used in derivatives trading, such as with options. A derivative is a financial instrument whose price is based (derived) from a different asset. The underlying asset is the financial instrument (e.g., stock, futures, commodity, currency, index) on which a derivative's price is based. For example, an option on a stock gives the holder the right to buy or sell the stock for a specified amount (strike price) at a certain date in the future (expiration). The underlying asset for the stock option contract is the company's stock. VANILLA OPTION: It is a normal option with no special or unusual features. WARRANT: It is a derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame. Warrants are often included in a new debt issue as a "sweetener" to entice investors. The main difference between warrants and call options is that warrants are issued and guaranteed by the company, whereas options are exchange instruments and are not issued by the company. Also, the lifetime of a warrant is often measured in years, while the lifetime of a typical option is measured in months. WRITING AN OPTION: It refers to the act of selling an option. An option is the right, but not the obligation, to buy or sell a particular trading instrument at a specified price, on or before its expiration. When someone writes (or "sells") an option, he or she must deliver to the buyer a specified number of shares if the option is exercised. The writer has an obligation to perform a duty while the buyer has the option to take action. There are two general types of option writing: covered and naked. In a covered call, the option writer already owns the underlying trading instrument and wishes to make extra money from the position. He or she can write (or sell) an option based on the expectation that the price of the underlying will move in a particular way. The buyer pays the writer a premium in exchange for writing the option. If the option trades at a value that benefits the buyer, the seller is obligated to hand over the shares. If the option expires at a value that does not benefit the buyer, the seller retains the original shares. If the option writer does not own the underlying instrument, it is said to be a "naked" option. This is more risky than writing a covered call since the writer is still obligated to produce the specified number of shares of the particular contract (without already owning them).
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