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Option

From Academic Kids

In finance, an option is a contract whereby the contract buyer has a right to exercise a feature of the contract (the option) on or before a future date (the exercise date). The 'writer' (seller) has the obligation to honour the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium.

Most often the term "options" refers to a derivative security, an option which gives the holder of the option the right to purchase or sell a security within a predefined time span in the future, for a predetermined amount. (Specific features of options on securities differ by the type of the underlying instrument involved.) However real options are another common type. A real option may be something as simple as the opportunity to buy or sell a house at a given price at some period in the future. The writer has the obligation to sell the house to the option buyer for the price agreed in the option while the option buyer does not have to purchase the house at all, so again the buyer has received something of value. Real options are an increasingly influential tool in corporate finance.

Contents

The option contract

For the option purchaser (also called the holder or taker), the option:

  • offers the right (but imposes no obligation),
  • to buy (call option) or sell (put option)
  • a specific quantity (e.g. 100)
  • of a given financial underlying (e.g. shares)
  • at an agreed price (exercise or strike price), or calculable value. For example the value can calculated be based on a reference rate or something else such as the average price of an underlying asset, as measured at agreed-upon intervals during the life of a contract, i.e. the Asian option.
  • either before maturity date (American option) or at a fixed maturity date (European option) or at certain fixed dates before end of maturity period (Bermudian option)
  • for a premium (option price).

The counterparty (option writer / seller) has an obligation to fulfill the contract if the option holder exercises the option. In return, the option seller receives the option price or premium.

Option frameworks

  • The buyer assumes a long position, and the writer a corresponding short position. (Thus the writer of a call option, is "short a call" and has the obligation to sell to the holder, who is "long of a call option" and who has the right to buy. The writer of a put option is "on the short side of the position", and has the obligation to buy from the taker of the put option, who is "long a put".)
  • The option style will affect the terms and valuation. Generally the contract will either be American style - which allows exercise before the maturity date - or European style - where exercise is on a fixed maturity date or Bermudian style - where exercise is on certain fixed dateswithin the maturity period. European contracts are easier to value and therefore to price. The contract can also be on an exotic option.
  • Buyers and sellers of options do not (usually) interact directly; the options exchange acts as intermediary and quotes the market price of the option. The seller guarantees the exchange that he can fulfill his obligation if the buyer chooses to execute.
  • The risk for the option holder is limited: he cannot lose more than the premium paid as he can "abandon the option". His potential gain is theoretically unlimited; see strike price.
  • The maximum loss for the writer of a put option is equal to the strike price. In general, the risk for the writer of a call option is unlimited. However, an option writer who owns the underlying instrument has created a covered position; he can always meet his obligations by using the actual underlying. Where the seller does not own the underlying on which he has written the option, he is called a "naked writer", and has created a "naked position".

Option pricing models

Historically the pricing of options was entirely ad hoc. Traders with good intuition about how other traders would price options made money and those without it lost money. Then in 1973 Fischer Black and Myron Scholes published a paper proposing what became known as the Black-Scholes pricing model, and for which Scholes received the 1997 Nobel Prize (Black had died, and was therefore not eligible). The model gave a theoretical value for simple put and call options, given assumptions about the behavior of stock prices. The availability of a good estimate of an option's theoretical price contributed to the explosion of trading in options. Researchers have subsequently generalized Black-Scholes to the Black model, and have developed other methods of option valuation, including Monte Carlo methods and Binomial options models.

Option uses

One can combine options and other derivatives in a process known as financial engineering to control the risk in a given transaction. The risk taken on can be anywhere from zero to infinite, depending on the combination of derivative features used.

Note, by using options, one party transfers (buys or sells) risk to or from another. When using options for insurance, the option holder reduces the risk he bears by paying the option seller a premium to assume it.

Because one can use options to assume risk, one can purchase options to create leverage. The payoff to purchasing an option can be much greater than by purchasing the underlying instrument directly. For example buying an at-the-money call option for 2 monetary units per share for a total of 200 units on a security priced at 20 units, will lead to a 100% return on premium if the option is exercised when the underlying security's price has risen by 2 units, whereas buying the security directly for 20 units per share, would have led to a 10% return. The greater leverage comes at the cost of greater risk of losing 100% of the option premium if the underlying security does not rise in price.

Other instruments to manage risk or to assume it include:

Employee stock options are also widely used as a compensation vehicle for employees and, in particular, senior executives of publicy traded corporations. However, employee stock options use is being curbed thanks in part to a decision by the Financial Accounting Standards Board (FASB) requiring that stock option grants are recorded on the income statement as an expense. Previously, options granted with fair market value exercise prices were not considered to have a cost to the company. This was a significant factor in their ascendancy as a compensation tool.

See also

Related: Call option, put option, moneyness, option time value, put-call parity, Black-Scholes, Black model, binomial options model, volatility smile, Option Adjusted Spread

Options: Stock option, warrants, foreign exchange options, interest rate options , bond options, options on futures, swaption, interest rate cap, interest rate floor, exotic interest rate option, credit default option, binary option, real option, option (films)

Finance articles: Derivatives market, derivative security, financial mathematics, financial economics, futures, finance, list of finance topics, list of finance topics (alphabetical)

External links

Clearing

de:Option (Wirtschaft) fr:option he:אופציה it:Opzione (Economia) ja:ストックオプション nl:Optie pl:Opcja (ekonomia) ru:Опцион

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