Option

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Option</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"> <p class="word_list"><a href="#American exercise">American exercise</a><p class="word_list"> <a href="#Bermudan exercise">Bermudan exercise</a><p class="word_list"> <a href="#call">call </a> <p class="word_list"><a href="#European exercise">European exercise</a><p class="word_list"> <a href="#expiration date">expiration date</a><p class="word_list"><a href="#option">option</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"> <p class="word_list"> <a href="#option holder">option holder</a><p class="word_list"><a href="#option issuer">option issuer</a><p class="word_list"> <a href="#option writer">option writer</a><p class="word_list"> <a href="#put">put</a><p class="word_list"><a href="#strike price"> strike price</a><p class="word_list"><a href="#vanilla option">vanilla option</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="left" id="table5"> <tr> <td width="300" height="14"><font size="2"> </font><font size="4"> </font></td> <td width="9" height="14"></td> </tr> <tr> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">An <b><a name="option">option</a></b> is a contract, or a provision of a contract, that gives one party (the <b> <a name="option holder">option holder</a></b>) the right, but not the obligation, to perform a specified transaction with another party (the <b><a name="option issuer">option issuer</a></b> or <b> <a name="option writer">option writer</a></b>) 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 <a href="../articles/corporate_bond.htm">corporate bond</a> 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 <a href="../articles/common_stock.htm">shares</a> of a particular <a href="../articles/common_stock.htm">stock</a> for a specified price.</p> <p class="body">Option contracts are a form of <a href="../articles/derivative_instrument.htm">derivative instrument</a>. Stand-alone options trade <a href="../articles/exchange_traded.htm">on exchanges</a> or <a href="../articles/exchange_traded.htm">OTC</a>. They are linked to a variety of <a href="../articles/derivative_instrument.htm">underliers</a>. Most exchange-traded options have stocks or <a href="../articles/future.htm">futures</a> as underliers. OTC options have a greater variety of underliers, including <a href="../articles/coupon_bond.htm">bonds</a>, currencies, physical commodities, <a href="../articles/swap.htm">swaps</a>, or <a href="../articles/basket_option.htm">baskets</a> of assets. Options can be embedded in almost any contract. Above, we gave examples of options embedded in a lease and a bond. </p> <p class="body">Options take many forms. The two most common are:</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="call">call</a></b> options, which provide the holder the right to purchase an underlier at a specified price;</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="put">put</a></b> options, which provide the holder the right to sell an underlier at a specified price.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">The <b><a name="strike price">strike price</a></b> 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 <b> <a name="expiration date">expiration date</a></b>. Options may allow for one of two forms of exercise:</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">With <b><a name="American exercise">American exercise</a></b>, the option can be exercised at any time up to the expiration date.</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">With <b><a name="European exercise">European exercise</a></b>, the option can be exercised only on the expiration date.</p> <p class="body">The origins of the names "American" and "European" in this context are unknown. They are unrelated to practices common in any particular geographic region.</p> <p class="body">A third form of exercise, which is occasionally used with OTC options, is <b><a name="Bermudan exercise">Bermudan exercise</a></b>. 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.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table7"> <tr> <td align="right" width="9"> </td> <td width="336">  <p style="margin-top: 0; margin-bottom: 2" class="ad_legend"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82402"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82402;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> </table> <p class="body">As an example, consider a three-month, European exercise, strike <a href="../articles/currency_codes.htm">USD</a> 22.50 put option on 100,000 barrels of Brent oil. Such an option might trade OTC. It has:</p> <p class="bullet" style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">underlier: Brent oil</p> <p class="bullet" style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/notional_amount.htm">notional amount</a>: 100,000 barrels</p> <p class="bullet" style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">expiration: in three months</p> <p class="bullet" style="margin-top: 3; margin-bottom: 3"> <img border="0" src="../images/bullet.gif" width="20" height="10">strike price: USD 22.50</p> <p class="body">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.</p> <p class="body">Puts and calls are sometimes called <b> <a name="vanilla option">vanilla options</a></b> to distinguish them from more <a href="../articles/derivative_instrument.htm">exotic</a> structures.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table8"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm"><strong style="font-weight: 400">derivative instrument</strong></a><strong style="font-weight: 400"> An instrument which derives its value from the value of other financial instruments. Article includes a list of vanilla and exotic derivatives.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/forward.htm">forward contract</a> A </strong>trade that is agreed to at one point in time but will take place at some later time.<p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/future.htm">future</a> An exchange-traded derivative that is similar to a forward.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/option_pricing_theory.htm">option pricing theory</a> The body of financial theory used by financial engineers to value options and other derivative instruments.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/options_spread.htm">option spreads</a> Positions combining one or more options in a single underlier.</p> <p class="explanatory_text" align="left"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="FONT-WEIGHT: 400"><a target="main" href="../articles/put_call_parity.htm">put-call parity</a> A formula that relates the price of a put to the price of a corresponding call.</strong></p> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/swap.htm">swap</a> A derivative whereby two parties exchange cash flow streams.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="FONT-WEIGHT: 400"><a href="../articles/time_value_and_intrinsic_value.htm">time value and intrinsic value</a> </strong> The two components that comprise an option's market value.</p> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table10"> <tr> <td width="100%"> <p class="explanatory_text">Kolb (<a target="_blank" href="http://www.riskbook.com/link/kolb_r_(2002).htm">2002</a>) is a practical introduction to derivatives. 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Read Baird (<a target="_blank" href="http://www.riskbook.com/link/baird_a_(1993).htm">1993</a>) after you read Natenberg.</p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap367"> <area target="_blank" href="http://www.riskbook.com/link/kolb_r_(2002).htm" shape="rect" coords="0, 0, 92, 124"> </map> <img border="0" src="../images/book_kolb_r_(2002)_125.gif" usemap="#FPMap367" width="93" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table12"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/kolb_r_(2002).htm"> Futures, Options and Swaps</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Robert Kolb</b></td> </tr> <tr> <td width="10%"> <map name="FPMap502"> <area href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="1, 2, 89, 15" target="_blank"></map> <img border="0" src="../images/star_4.gif" usemap="#FPMap502" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap316"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map><img border="0" src="../images/tech_2.gif" usemap="#FPMap316" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2002</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap366"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/kolb_r_(2002).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap366" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap500"> <area target="_blank" href="http://www.riskbook.com/link/cox_and_rubinstein_(1985).htm" shape="rect" coords="0, 0, 80, 124"> </map> <img border="0" src="../images/book_cox_and_rubinstein_(1985)_125.gif" usemap="#FPMap500" width="81" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/cox_and_rubinstein_(1985).htm"> Options Markets</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>John C. Cox and Mark Rubinstein</b></td> </tr> <tr> <td width="10%"><map name="FPMap499"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_classic.gif" usemap="#FPMap499" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap427"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map><img border="0" src="../images/tech_2.gif" usemap="#FPMap427" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1985</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap498"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/cox_and_rubinstein_(1985).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap498" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap501"> <area target="_blank" href="http://www.riskbook.com/link/natenberg_s_(1994).htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_natenberg_s_(1994)_125.gif" usemap="#FPMap501" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table16"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/natenberg_s_(1994).htm"> Option Volatility & Pricing</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Sheldon Natenberg</b></td> </tr> <tr> <td width="10%"> <img border="0" src="../images/star_5.gif" usemap="#FPMap563" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <img border="0" src="../images/tech_2.gif" usemap="#FPMap564" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1994</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap497"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/natenberg_s_(1994).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap497" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table17"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap504"> <area target="_blank" href="http://www.riskbook.com/link/baird_a_(1993).htm" shape="rect" coords="0, 0, 82, 124"> </map> <img border="0" src="../images/book_baird_(1993)_125.gif" usemap="#FPMap504" width="83" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table18"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/baird_a_(1993).htm"> Option Market Making</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Allen Jan Baird</b></td> </tr> <tr> <td width="10%"> <img border="0" src="../images/star_5.gif" usemap="#FPMap563" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <img border="0" src="../images/tech_2.gif" usemap="#FPMap564" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">1993</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap503"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/baird_a_(1993).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap503" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_2.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; 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