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
trade on exchanges or
OTC. They are linked to a variety of
Most exchange-traded options have stocks or
futures as underliers. OTC
options have a greater variety of underliers, including
currencies, physical commodities,
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
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.
instrument An instrument
which derives its value from the value of other financial
instruments. Article includes a list of vanilla and exotic derivatives.
A trade that is agreed to at one point in time but will
take place at some later time.
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
spreads Positions combining one or more options in a single
A formula that relates the price of a put to the price of a
A derivative whereby two parties exchange cash flow streams.
time value and
The two components that comprise an option's market value.
is a practical introduction to derivatives. Cox and Rubinstein (1985)
is a classic. Pretty much everyone who works with options has read
it at some point. Natenberg (1994)
is an excellent introduction to options trading. Read Baird (1993)
after you read Natenberg.
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