In finance, an option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction – that is to sell or buy – if the buyer (owner) “exercises” the option. The buyer pays a premium to the seller for this right. An option which conveys to the owner the right to buy something at a specific price is referred to as a call; an option which conveys the right of the owner to sell something at a specific price is referred to as a put. Both are commonly traded, but for clarity, the call option is more frequently discussed.

Options valuation is a topic of ongoing research in academic and practical finance. In basic terms, the value of an option is commonly decomposed into two parts:

  1. The first part is the intrinsic value, which is defined as the difference between the market value of the underlying and the strike price of the given option.
  2. The second part is the time value, which depends on a set of other factors which, through a multi-variable, non-linear interrelationship, reflect the discounted expected value of that difference at expiration.

Contract specifications

Every financial option is a contract between 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.

Types of Options

Options can be classified in a few ways.

  • According to the option rights
  • Call option
  • Put option
  • According to the underlying assets
  • Equity option
  • Bond option
  • Future option
  • Index option
  • Commodity option

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:

  • interest rate options
  • currency cross rate options, and
  • 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.

Valuation models

The value of an option can be estimated using a variety of quantitative 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.

Risks

As with all securities, trading options entails the risk of the option’s value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlying and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict.

Pin risk

A special situation called pin risk can arise when the underlying closes at or very close to the option’s strike value on the last day the option is traded prior to expiration. The option writer (seller) may not know with certainty whether or not the option will actually be exercised or be allowed to expire worthless. Therefore, the option writer may end up with a large, unwanted residual position in the underlying when the markets open on the next trading day after expiration, regardless of his or her best efforts to avoid such a residual.

Counterparty risk

A further, often ignored, risk in derivatives such as options is counterparty risk. In an option contract this risk is that the seller won’t sell or buy the underlying asset as agreed. The risk can be minimized by using a financially strong intermediary able to make good on the trade, but in a major panic or crash the number of defaults can overwhelm even the strongest intermediaries.

Trading

The most common way to trade options is via standardized options contracts that are listed by various futures and options exchanges. Listings and prices are tracked and can be looked up by ticker symbol. By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include:

fulfillment of the contract is backed by the credit of the exchange, which typically has the highest rating (AAA),

counterparties remain anonymous,

enforcement of market regulation to ensure fairness and transparency, and

maintenance of orderly markets, especially during fast trading conditions.

Over-the-counter options contracts are not traded on exchanges, but instead between two independent parties. Ordinarily, at least one of the counterparties is a well-capitalized institution. By avoiding an exchange, users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition, OTC option transactions generally do not need to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must establish credit lines with each other, and conform to each other’s clearing and settlement procedures.

With few exceptions, there are no secondary markets for employee stock options. These must either be exercised by the original grantee or allowed to expire worthless.

The basic trades of traded stock options (American style) are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging. An option contract in US markets usually represents 100 shares of the underlying security.

Long call

A trader who believes that a stock’s price will increase might buy the right to purchase the stock (a call option) at a fixed price, rather than just purchase the stock itself. A buyer would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price(spot Price,S) at expiration is above the exercise price(X) by more than the premium (price) paid P, he will profit i.e. if S-X>P, the deal is profitable. If the stock price at expiration is lower than the exercise price, he will let the call contract expire worthless, and only lose the amount of the premium.

Long put

A trader who believes that a stock’s price will decrease can buy the right to sell the stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid, he will profit. If the stock price at expiration is above the exercise price, he will let the put contract expire worthless and only lose the premium paid.In the whole story, the premium also plays a major role as it enhances the break-even point.

Short call

A trader who believes that a stock price will decrease can sell the stock short or instead sell, or “write”, a call. The trader selling a call has an obligation to sell the stock to the call buyer, at the buyer’s option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.

Short put

A trader who believes that a stock price will increase can buy the stock or instead sell, or “write”, a put. The trader selling a put has an obligation to buy the stock from the put buyer, at the buyer’s option. If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock.

Option strategies

Combining any of the four basic kinds of option trades (possibly with different exercise prices and maturities) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.

Strategies are often used to engineer a particular risk profile to movements in the underlying security. For example, buying a butterfly spread (long one X1 call, short two X2 calls, and long one X3 call) allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss.

An Iron condor is a strategy that is similar to a butterfly spread, but with different strikes for the short options – offering a larger likelihood of profit but with a lower net credit compared to the butterfly spread.

Selling a straddle (selling both a put and a call at the same exercise price) would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss.

Similar to the straddle is the strangle which is also constructed by a call and a put, but whose strikes are different, reducing the net debit of the trade, but also reducing the risk of loss in the trade.

One well-known strategy is the covered call, in which a trader buys a stock (or holds a previously-purchased long stock position), and sells a call. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the call will not be exercised, and any loss incurred to the trader will be partially offset by the premium received from selling the call.