Option - Wikipedia, the free encyclopedia http://en.wikipedia.

org/wiki/Option

Option
From Wikipedia, the free encyclopedia.

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
1 The option contract
2 Option frameworks
3 Option pricing models
4 Option uses
5 See also
6 External links
6.1 Clearing

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 be calculated 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

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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 dates within 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".

Options can be in-the-money, at-the-money or out-of-the-money. The "in-the-money" option has a positive intrinsic
value, options in "at-the-money" or "out-of-the-money" have an intrinsic value of zero. Additional to the intrinsic
value an option has a time value, which decreases, the closer the option is to its expiry date.

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:

Futures
Forwards

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Swaps

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
Options Dictionary (http://www.cboe.com/LearnCenter/Glossary.aspx) , Chicago Board Options Exchange
Daily and historical options prices for commonly traded futures (http://www.futuresquotes.com/)
Options Glossary (http://biz.yahoo.com/opt/glossary1.html) , Yahoo! Finance
Options Database (http://www.global-derivatives.com/options/o-types.php) , global-derivatives.com
Options Industry Council (http://www.888options.com/)
Investopedia Options tutorial (http://www.investopedia.com/university/options/)
Fundamentals of Options (http://www.quantnotes.com/fundamentals/)
Daily Stock Options News and Information (http://www.stockoptionsinfo.com)

Clearing

The Options Clearing Corporation (http://www.optionsclearing.com/) (the largest clearing organization in the
world for options)

Retrieved from "http://en.wikipedia.org/wiki/Option"

Categories: Derivatives | Contract law

This page was last modified 00:55, 29 August 2005.

All text is available under the terms of the GNU Free Documentation License (see Copyrights for
details).

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