Option

Explained:

American exercise

Bermudan exercise

call

European exercise

expiration date

option

option holder

option issuer

option writer

put

strike price

vanilla option

 
   

An option is a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. The owner of a property might sell another party an option to purchase the property any time during the next three months at a specified price. A lease might contain a provision granting the renter the option to extend the lease for an additional year. A corporate bond might have an option provision allowing the issuer to purchase the bond back from the purchaser five years prior to maturity for a specified price. A speculator might purchase an option to sell at any time during the next three months 100 shares of a particular stock for a specified price.

Option contracts are a form of derivative instrument. Stand-alone options trade on exchanges or OTC. They are linked to a variety of underliers. Most exchange-traded options have stocks or futures as underliers. OTC options have a greater variety of underliers, including bonds, currencies, physical commodities, swaps, or baskets of assets. Options can be embedded in almost any contract. Above, we gave examples of options embedded in a lease and a bond.

   

Options take many forms. The two most common are:

call options, which provide the holder the right to purchase an underlier at a specified price;

put options, which provide the holder the right to sell an underlier at a specified price.

The strike price of a call (put) option is the contractual price at which the underlier will be purchased (sold) in the event that the option is exercised. The last date on which an option can be exercised is called the expiration date. Options may allow for one of two forms of exercise:

With American exercise, the option can be exercised at any time up to the expiration date.

With European exercise, the option can be exercised only on the expiration date.

The origins of the names "American" and "European" in this context are unknown. They are unrelated to practices common in any particular geographic region.

   

A third form of exercise, which is occasionally used with OTC options, is Bermudan exercise. A Bermuda option can be exercised on a few specific dates prior to expiration. Yes, the name was chosen because Bermuda is half way between America and Europe.

As an example, consider a three-month, European exercise, strike USD 22.50 put option on 100,000 barrels of Brent oil. Such an option might trade OTC. It has:

underlier: Brent oil

notional amount: 100,000 barrels

expiration: in three months

strike price: USD 22.50

It gives the holder the right, but not the obligation, to sell the issuer 100,000 barrels of Brent oil three months from today for a price of USD 22.50 per barrel.

Puts and calls are sometimes called vanilla options to distinguish them from more exotic structures.

Related Books

       

Related Internal Links

derivative instrument An instrument which derives its value from the value of other financial instruments. Article includes a list of vanilla and exotic derivatives.

forward contract A trade that is agreed to at one point in time but will take place at some later time.

future An exchange-traded derivative that is similar to a forward.

option pricing theory The body of financial theory used by financial engineers to value options and other derivative instruments.

option spreads Positions combining one or more options in a single underlier.

put-call parity A formula that relates the price of a put to the price of a corresponding call.

swap A derivative whereby two parties exchange cash flow streams.

time value and intrinsic value The two components that comprise an option's market value.

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copyright © Glyn A. Holton, 2002

Although the information in this website has been presented with care and obtained from sources the author believes to be reliable, there is no guarantee that it is accurate. Such information may be incomplete, condensed, outdated or presented with errors. The content of the website is for information purposes only. It is provided gratuitously, so the author shall not be liable under any theory for any damages suffered by any user. The author does not provide investment advice, and this website is not a vehicle for communicating investment advice.