What Are Options

Option, being contracts at law, creates a legal relationship between buyer and seller of the option. The buyer (or holder) of the option has the right, but not the obligation, to buy or sell a specified asset at a specified price, at or before a future date, from the seller (or writer) of the option. The seller of the option contract has the obligation to honor the terms of options when the buyer exercises that right.

Buyer will exercise the option when the price of the underlying asset makes it profitable to do so. Because the options buyer is not obliged to buy or sell the underlying assets, he is protected from unfavorable market conditions. The risk of loss is therefore carried by the seller. For taking on this risk, the seller is charging the buyer a fee or premium.

Types of Options

There are two types of options, the exchange-traded (ET) options and the over-the-counter (OTC) options. Exchange-traded options are traded on a formalized exchanged. Equity options and the future options are the most common types of this. ET options transactions are settled through a clearing house that supervises the collection and disbursement of premiums and margins. ET options are highly standardized as to the type and maturity of the underlying instrument.

On the other hand, over-the-counter (OTC) options are not traded at a centralized market place or through a formalized trading system. Buyers and sellers arrange deals on the phone or through face-to-face meetings. OTC options are customized options agreement between the buyers and sellers because it has tailor- made terms such as quality, delivery date or maturity. The benefit of its lack of standardization is that, it can more exactly meet the needs of the involved parties.

Key Elements of an Option

There are five key elements of an exchange traded options contract:

• Types of options: Two basic types of option are call and put options. A call option gives the option buyer the right to buy a specified asset at a specified price at or before a specified date. While a put option gives the buyer the right to sell a specified asset at a specified price at or before a specified date.
• Underlying assets: Options are traded over many underlying instruments such as gold, equities, futures, currencies or interest rate.
• Strike price: The strike price or exercise price is the agreed price at which the underlying asset will be traded if the option is exercised.
• Expiry date and exercise style: Expiry date of the option is the last day on which the option expires. An option can either be American style or European style. For American style option, buyer can exercise his right at any time from the date of purchase up until the expiry date. For European style, buyer can only exercise the option contract on the specified expiry date.
• Premium or price: The premium is the cost or price of the option paid by the option buyer to the option seller. The premiums are determined by the competitive bid and offer.