What do you understand by Option (finance)?

In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset.

An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless.

In return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised.

An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized ad hoc to the desires of the buyer, usually by an investment bank.

Option valuation

The theoretical value of an option is evaluated according to any of several mathematical models. These models, which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to changing conditions. For example how the price changes with respect to changes in time to expiration or how an increase in volatility would have an impact on the value. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other.

Contract specifications

Every financial option is a contract between the 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 (a call option) or the right to sell (a put option)

• the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B stock)

• 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 of the option.

Types

The Options can be classified into following types:

Exchange-traded options

• Exchange-traded options (also called "listed 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 credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include:

  • stock options,

  • commodity options,

  • bond options and other interest rate options

  • stock market index options or, simply, index options and

  • options on futures contracts

  • callable bull/bear contract

Over-the-counter

• Over-the-counter options (OTC options, also called "dealer 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, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include:

1. interest rate options

2. currency cross rate options, and

3. options on swaps or swaptions.

Other option types

Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Option styles

• European option – an option that may only be exercised on expiration.

• American option – an option that may be exercised on any trading day on or before expiry.

• Bermudan option – an option that may be exercised only on specified dates on or before expiration.

• Barrier option – any option with the general characteristic that the underlying security’s price must pass a certain level or "barrier" before it can be exercised.

• Exotic option – any of a broad category of options that may include complex financial structures.

• Vanilla option – any option that is not exotic.

Valuation models

The value of an option can be estimated using a variety of quantitative techniques based on the concept of risk neutral pricing and using stochastic calculus. The most basic model is the Black-Scholes model. More sophisticated models are used to model the volatility smile. These models are implemented using a variety of numerical techniques. In general, standard option valuation models depend on the following factors:

• The current market price of the underlying security,

• the strike price of the option, particularly in relation to the current market price of the underlying (in the money vs. out of the money),

• the cost of holding a position in the underlying security, including interest and dividends,

• the time to expiration together with any restrictions on when exercise may occur, and

• an estimate of the future volatility of the underlying security’s price over the life of the option.

More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates.

The following are some of the principal valuation techniques used in practice to evaluate option contracts.