An option is a contract between two parties in which the buyer has the right (but not the obligation) to buy or sell a specified asset at a specified price at (or before) a specified date, from the seller. The seller of the option is obligated to transact if the buyer exercises that right.
The buyer of the option is not obliged to complete the deal. The option protects the buyer from unfavorable market conditions. However, if changes in price are in the buyer’s favor, buyer could make a profit by completing the deal. The risk of loss is carried by the seller. For that reason, seller charges the buyer a fee and this fee is called the premium.
This feature distinguish an option contact from other instruments such as forward contracts or future contracts, in which both parties to the contract have an obligation to transaction at some time in the future. In an option contract, only the seller has an obligation to transact. However, this is only if the buyer requires the seller to do so. The act of enforcing the buyer’s rights under an option contract is called exercising the options.
Options create a legal relationship between the buyer and the seller of the option contract. This relationship can remain in place until the option is exercised. It is allowed to lapse if the option is not exercised prior to or on the expiration date. Besides, it is possible for buyer and seller of the option contract to enter into an ‘opposite’ contract and for these contracts to be offset against each other.
Option Buyer
The person who buys the option has right, but not the obligation, to do either buy the underlying asset (in case of an call option) or sell the underlying asset (in case of an put option). Buying an option is sometimes referred as taking an option. The buyer is also called the taker.
Option Seller
The seller of an option is obligated to either sell the underlying asset (in case of an call option) or buy the underlying asset (in case of an put option). Seller is in the opposite position of the buyer. Selling an option is sometimes referred as writing or granting an option. The seller is also called the writer or grantor.
Filed under All About Options, Option Basics by on Apr 16th, 2010. Comment. 
There are five key elements of an exchange-traded option contract:
1. Types of Options
An option can be a call option or a put option.
A call option gives the option buyer the right to buy a specified asset at a specified price at or before a specified date. The option seller is obliged to sell the underlying asset to the option buyer if the buyer decides to exercise this right.
A put option gives the option buyer the right to sell a specified asset at a specified price at or before a specified date. The option seller is obliged to buy the underlying asset to the option buyer if the buyer decides to exercise this right.
2. Underlying Asset of an Option
An underlying asset of an option contract can be
- an asset (such as s specific stock) or
- an index or
- a particular futures contract or
- a debt instrument or
- a foreign currency or
- a commodity (such as gold)
3. Strike Price or Exercise Price of an Option
The strike price is also called the exercise price. It is the agreed price at which the underlying asset will be traded if the option is exercised.
A call option is in-the-money if the price of the underlying asset is higher than the strike price
A call option is out-of-the-money if the price of the underlying asset is lower than the strike price
A put option is in-the-money if the price of the underlying asset is lower than the strike price
A put option is out-of-the-money if the price of the underlying asset is higher than the strike price
4. Expiry Date and Exercise Style of an Option
The expiry date of an option is also known as maturity date or exercise date or the declaration of an option. It is the last day on which the option may be exercised.
An option can either be:
American style: Option can be exercised by the buyer at any time from the date of purchase up until (and including) expiry date.
European style: Option can be exercised by the buyer only on the specified expiry date.
5. Option Premium
Option premium is the cost or price of the option. It is the amount paid by the buyer of an option to the seller of an option.
Filed under All About Options, Option Basics by on Apr 16th, 2010. Comment.
Options have been there for more than a century. Options on equity stocks were available on the London Stock Exchange more than a century ago. Chicago Board Options Exchange (CBOE) was the first formalized options market that offered exchange-traded options on US listed equity stocks. It was established in 1973. Since then, several stock exchanges, such as Australia Stock Exchange, emulated the CBOE market and offered exchange-traded options market on equity stocks. There exists a great diversity of exchange-traded options markets on equities, currencies, debt instruments, stock index instruments.
There are two types of options:
- Exchange-traded options
- Over-the-counter options
The differences between these two types of options are listed in the table below:
| Exchange-traded options (ET options) | Over-the-counter options (OTC Options) |
| Options that are originated and traded on a formalized exchanged | OTC options are not traded at a centralized market place or through a formalized trading system. |
| Most commonly traded ET options are equity options and futures options | OTC markets exist in commodities, equities, stock indices, debt instruments and foreign exchange. |
| ET transactions are settled through a clearing house, associated with the exchange. | There is no clearing house. |
| ET options are floor traded on a physical floor or traded on a screen-based trading system. | OTC options are traded through face-to-face meetings or over the telephone. |
| ET options are highly standardized as to the type and maturity of the underlying instrument. | OTC options are tailor-made option agreements between two or more parties. The contracts are not standardized. |
Filed under All About Options, Option Basics by on Apr 16th, 2010. Comment.