What is Option?
An option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset.
An option which conveys the right to buy something is called a call; an option which conveys the right to sell is called a put. The reference price at which the underlying may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless.
In return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised.
An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized ad hoc to the desires of the buyer, usually by an investment bank.
Naming conventions are used to help identify properties common to many different types of options. These include:
- European option – an option that may only be exercised on expiration.
- American option – an option that may be exercised on any trading day on or before expiry.
- Bermudan option – an option that may be exercised only on specified dates on or before expiration.
- Barrier option – any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised.
- Exotic option – any of a broad category of options that may include complex financial structures. Vanilla option – any option that is not exotic.
