In finance, an option is a contract that gives the holder the right, but not the obligation, to buy or sell a specific quantity of an underlying asset at a set price, known as the strike price, on or before a specified date. Options are typically acquired through purchase, as compensation, or as part of a financial transaction. They have a value based on the relationship between the asset price, time until expiration, market volatility, risk-free interest rate, and the strike price. Options can be traded in public markets through standardized contracts or privately in over-the-counter (OTC) transactions.
Definition and Application
An option allows its holder to buy or sell an underlying asset at a strike price before or on a specified date. There are two main types of options: call options and put options. A call option grants the right to buy the asset, while a put option grants the right to sell it. The strike price can be based on the asset’s market price at the time of the option’s issuance or set at a discount or premium.
Options can be part of other transactions, such as share issues or employee incentives, or bought directly by paying a premium. A call option is generally exercised when the strike price is below the asset’s market value, and a put option is exercised when the strike price is above the market value. If the option is not exercised before the expiration date, it expires worthless, and the holder loses the premium paid. The issuer of the option earns the premium as income.
Options can be resold in secondary markets, either through OTC transactions or on options exchanges. The market price of an option often reflects the difference between the asset’s market price and the strike price. Factors such as the need to sell the option before expiration or attempts to acquire large option holdings can affect its market price. Holding an option does not grant any rights associated with the underlying asset, such as voting rights or dividends.
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History
Contracts similar to options have existed since ancient times. The earliest recorded option buyer was Thales of Miletus, an ancient Greek mathematician who successfully used options to profit from an expected olive harvest. In 1688, the book Confusion of Confusions described the trading of “opsies” on the Amsterdam stock exchange. Options, including puts and calls, became well-known trading instruments in London during the 1690s. They were used in various markets, including real estate and film, and have been part of bond contracts and lines of credit.
Modern Stock Options
Options trading has evolved significantly. The Chicago Board Options Exchange, established in 1973, introduced standardized contracts and a clearing house for trading options. Today, options are traded on regulated exchanges and customized through bilateral agreements. Options are a type of derivative financial instrument.
Contract Specifications
An option contract typically includes the following details:
- The type of option (call or put)
- The quantity and class of the underlying asset
- The strike price
- The expiration date
- The settlement terms (whether actual delivery or cash payment)
- The method for converting the quoted price into the actual premium paid
Types of Options
Options can be classified by:
- Rights: Call options (right to buy) and put options (right to sell).
- Delivery Type: Physical delivery or cash settlement.
- Underlying Assets: Equity, bond, future, index, commodity, currency, or swap options.
Other types include employee stock options, real estate options, and prepayment options in mortgages.
Option Styles
Options are categorized into styles such as:
- American Options: Exercisable on any trading day before expiration.
- European Options: Exercisable only on the expiration date.
- Bermudan Options: Exercisable on specified dates before expiration.
- Asian Options: Payoffs based on average asset price over a period.
- Barrier Options: Activated or voided when the asset price crosses a certain level.
- Binary Options: Pay a fixed amount if conditions are met on expiration.
- Exotic Options: Include complex financial structures.
Conclusion
Options are versatile financial instruments used for various purposes, including speculation, hedging, and compensation. Understanding their mechanics, risks, and market behaviors is essential for effective use and management.
