Chapter 2: Key elements in option contract
There are some key terms in an option contract you must be familiar with before going further in this section. The most important elements of an option contract are:
- Underlying Asset
- Strike Price (Exercise Price)
- Expiry Date
- Exercise Style
- Contract Size
- Settlement style
1. Underlying Asset
Underlying Asset refers to the asset to be exchanged if the option is exercised. For example, a call option on the shares of XYZ Company gives the holder the right to buy the shares of XYZ Company. A put option on the Hang Seng Index gives the holder the right to sell the index.
||Shares of XYZ
|Hang Seng Index Put
||Hang Seng Index
Type refers to the two basic types of options: CALLS and PUTS.
Call options give the buyer the right to buy the underlying asset.
Put options give the buyer the right to sell the underlying asset.
3) Strike Price
Strike Price (or Exercise Price) refers to the pre-determined price at which the underlying asset can be bought or sold.
4) Expiry Date
Expiry Date refers to the date on which that the option contract, and hence the right to exercise, will expire.
5) Exercise Style
Exercise Style refers to when the option contract can be exercised. There are two styles, European and American.
European style options can only be exercised on the expiry date, while American style options can be exercised at any time on or before expiry.
The exercise style for the stock option contracts and index option contracts traded on the Exchange is American style and European style respectively.
6) Contract Size
Contract Size refers to the amount of the underlying asset that one option contract represents.
7) Settlement style
Settlement style refers to the way the underlying assets change hands on exercise by the option holder.
Physical settlement involves physical delivery of the underlying assets between the holder and the writer while cash settlement involves a cash transfer of the price difference between the strike price and underlying asset.
At HKEX, the settlement style of stock option is physical while index option is cash.