Option (finance)


In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option.
Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. Thus, they are also a form of asset and have a valuation that may depend on a complex relationship between underlying asset price, time until expiration, market volatility, the risk-free rate of interest, and the strike price of the option.
Options may be traded between private parties in over-the-counter transactions, or they may be exchange-traded in live, public markets in the form of standardized contracts.

Definition and application

An option is a contract that allows the holder the right to buy or sell an underlying asset or financial instrument at a specified strike price on or before a specified date, depending on the form of the option. Selling or exercising an option before expiry typically requires a buyer to pick the contract up at the agreed upon price. The strike price may be set by reference to the spot price of the underlying security or commodity on the day an option is issued, or it may be fixed at a discount or at a premium. The issuer has the corresponding obligation to fulfill the transaction if the holder "exercises" the option. An option that conveys to the holder the right to buy at a specified price is referred to as a call, while one that conveys the right to sell at a specified price is known as a put.
The issuer may grant an option to a buyer as part of another transaction, or the buyer may pay a premium to the issuer for the option. A call option would normally be exercised only when the strike price is below the market value of the underlying asset, while a put option would normally be exercised only when the strike price is above the market value. When an option is exercised, the cost to the option holder is the strike price of the asset acquired plus the premium, if any, paid to the issuer. If the option's expiration date passes without the option being exercised, the option expires, and the holder forfeits the premium paid to the issuer. In any case, the premium is income to the issuer, and normally a capital loss to the option holder.
An option holder may on-sell the option to a third party in a secondary market, in either an over-the-counter transaction or on an options exchange, depending on the option. The market price of an American-style option normally closely follows that of the underlying stock being the difference between the market price of the stock and the strike price of the option. The actual market price of the option may vary depending on a number of factors, such as a significant option holder needing to sell the option due to the expiration date approaching and not having the financial resources to exercise the option, or a buyer in the market trying to amass a large option holding. The ownership of an option does not generally entitle the holder to any rights associated with the underlying asset, such as voting rights or any income from the underlying asset, such as a dividend.

History

Historical uses of options

Contracts similar to options have been used since ancient times. The first reputed option buyer was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the season's olive harvest would be larger than usual, and during the off-season, he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected, he exercised his options and then rented the presses out at a much higher price than he paid for his 'option'.
The 1688 book Confusion of Confusions describes the trading of "opsies" on the Amsterdam stock exchange, explaining that "there will be only limited risks to you, while the gain may surpass all your imaginings and hopes."
In London, puts and "refusals" first became well-known trading instruments in the 1690s during the reign of William and Mary. Privileges were options sold over the counter in nineteenth-century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was fixed at a rounded-off market price on the day or week that the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets.
In the real estate market, call options have long been used to assemble large parcels of land from separate owners; e.g., a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless they can buy all the plots in the entire parcel. Additionally, purchase of real property, like houses, requires a buyer paying the seller into an escrow account an earnest payment, which offers the buyer the right to buy the property at the set terms, including the purchase price.
In the motion picture industry, film or theatrical producers often buy an option giving the right – but not the obligation – to dramatize a specific book or script.
Lines of credit give the potential borrower the right – but not the obligation – to borrow within a specified time period.
Many choices, or embedded options, have traditionally been included in bond contracts. For example, many bonds are convertible into common stock at the buyer's option, or may be called at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early, which corresponds to a callable bond option.

Modern stock options

Options contracts have been known for decades. The Chicago Board Options Exchange was established in 1973, which set up a regime using standardized forms and terms and trade through a guaranteed clearing house. Trading activity and academic interest have increased since then.
Today, many options are created in a standardized form and traded through clearing houses on regulated options exchanges. In contrast, other over-the-counter options are written as bilateral, customized contracts between a single buyer and seller, one or both of which may be a dealer or market-maker. Options are part of a larger class of financial instruments known as derivative products, or simply, derivatives.

Contract specifications

A financial option is a contract between two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:
  • whether the option holder has the right to buy or the right to sell
  • the quantity and class of the underlying asset
  • the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise
  • the expiration date, or expiry, which is the last date the option can be exercised
  • the settlement terms, for instance, whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount
  • the terms by which the option is quoted in the market to convert the quoted price into the actual premium – the total amount paid by the holder to the writer

    Option trading

Forms of trading

Exchange-traded options

Exchange-traded options are a class of exchange-traded derivatives. Exchange-traded options have standardized contracts and are settled through a clearing house with fulfillment guaranteed by the Options Clearing Corporation. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include:
options are traded between two private parties and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, the option writer is a well-capitalized institution. Option types commonly traded over the counter include:
By avoiding an exchange, users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition, OTC option transactions generally do not need to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must establish credit lines with each other and conform to each other's clearing and settlement procedures.
With few exceptions, there are no secondary markets for employee stock options. These must either be exercised by the original grantee or allowed to expire.

Exchange trading

The most common way to trade options is via standardized options contracts listed by various futures and options exchanges. Listings and prices are tracked and can be looked up by ticker symbol. By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include:
  • Fulfillment of the contract is backed by the credit of the exchange, which typically has the highest rating,
  • Counterparties remain anonymous,
  • Enforcement of market regulation to ensure fairness and transparency, and
  • Maintenance of orderly markets, especially during fast trading conditions.

    Basic trades (American style)

These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. An option contract in US markets usually represents 100 shares of the underlying security.