Option

In finance, an option is a contract whereby the contract buyer has a right to exercise a feature of the contract (the option) at future date (the exercise date), and the seller has the obligation to deliver the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium.

Table of contents

1 The option contract
2 Option frameworks
3 Option pricing models
4 Option uses
5 See also

The option contract

For the option purchaser (also called the holder or taker), the option:

offers the right (but imposes no obligation),
to buy (call option) or sell (put option)
a specific quantity
of a given financial underlying
at an agreed price (exercise or strike price), or calculable value (based on a reference rate)
either before maturity date (American option) or at a fixed maturity date (European option)
for a premium (option price).

The counterparty (option writer / seller) has an obligation to fulfill if the option holder exercises the option. In return, the option seller receives the option price or premium .

Option frameworks

The buyer assumes a long position, and the seller a corresponding short position. (Thus the seller of a call, is "short a call" and has the obligation to sell to the holder, who is "long of a call option" and who has the right to buy. The writer of a put is "on the short side of the position", and has the obligation to buy from the taker of the put option, who is "long a put".)

The option style will effect the terms and valuation. Generally the contract will either be American style - which allows exercise before the maturity date - or European style - where exercise is on a fixed maturity date. European contracts are easier to value and therefore to price. The contract can also be on an exotic option.
Buyers and sellers of options do not (usually) interact directly; the options exchange acts as intermediary and quotes the market price of the option. The seller guarantees the exchange that he can fulfill his obligation if the buyer chooses to execute.
The risk for the option holder is limited: he cannot lose more than the premium paid as he can "abandon the option". His potential gain is theoretically unlimited; see strike price.
The maximum loss for the writer of a put option is equal to the strike price. In general, the risk for the writer of a call option is unlimited. However, an option writer who owns the underlying instrument has created a covered position; he can always meet his obligations by using the actual underlying. Where the seller does not own the underlying on which he has written the option, he is called a "naked writer", and has created a "naked position".
Options can be in-the-money, at-the-money or out-of-the-money. The "in-the-money" option has a positive intrinsic value, options in "at-the-money" or "out-of-the-money" have an intrinsic value of zero. Additional to the intrinsic value an option has a time value, which decreases, the closer the option is to its expiry date (also see Option time value).
Generally the term "options" refers to a derivative security, an option which gives the holder of the option the right to purchase or sell a security at a predefined time in the future, for a predetermined amount. (Specific features of options on securities differ by the type of the underlying instrument involved.) However the term also applies to something as simple as the opportunity to purchase a house at a given price over some period in the future. This type of non-security option is known as a real option and is an increasingly influential tool in corporate finance. One can even think of life insurance as a put option - the holder has paid a premium for the right to put a corpse (or more likely a death certificate) to an insurance company in return for the face value of the insurance policy.

Option pricing models

Historically the pricing of options was entirely ad hoc. Traders with good intuition about how other traders would price options made money and those without it lost money. Then in 1973 Fischer Black and Myron Scholes published a paper proposing what became known as the Black-Scholes pricing model, and for which they received the Nobel Prize in Economics. The model gave a theoretical value for simple put and call options, given assumptions about the behavior of stock prices. The availability of a good estimate of an option's theoretical price contributed to the explosion of trading in options. Researchers have subsequently generalized Black-Scholes to the Black model, and have developed other methods of option valuation , including Monte Carlo methods and Binomial options models.

Option uses

One can combine options and other derivatives in a process known as financial engineering to control the risk in a given transaction. The risk taken on can be anywhere from zero to infinite, depending on the combination of derivative features used.

Note, by using options, one party transfers (buys or sells) risk to or from another. When using options for insurance, the option holder reduces the risk he bears by paying the option seller a premium to assume it.

Because one can use options to assume risk, one can purchase options to create leverage. The payoff to purchasing an option can be much greater than by purchasing the underlying instrument directly. For example buying an at-the-money call option for $2 per share for a total of $200 on a security priced at $20, will lead to a 100% return on premium if the option is exercised when the underlying security's price has risen by $2, whereas buying the security directly for $20 per share, would have lead to a 10% return. The greater leverage comes at the cost of greater risk of losing 100% of the option premium if the underlying security does not rise in price.

Other instruments to manage risk or to assume it include: