Options are contracts that give the holder the option to buy/sell specified quantity of the underlying assets at a particular (strike) price on or before a specified time period. The word ‘option’ implies that the holder of the options has the right but not the obligation to buy or sell underlying assets. The underlying may be physical commodities such as wheat /rice/ cotton / oilseeds / gold or financial instruments such as equity shares stock index, bonds and so on. In a forward or futures market, the two parties commit to buy and sell. While the option gives the holder of the option the right to buy or ell. However, the holder of the options has to pay the price of options, termed as the premium. If the holder does not exercise the options, he loses only the premium. Hence, options are fundamentally different from forward or futures.
Types of Options:
Options are of two basic types – ‘call’ option and ‘put’ option. A call option is a right to buy an underlying asset at a specified price on or before a particular day by paying a premium. A ‘put’ option is a right to sell an underlying asset at a specified price on or before a particular day by paying a premium.
There are two other important types of options: European style options and American style options. European style options can be exercised only on the maturity date of the option, which is known as the expiry date. American style options can be exercised at any time before and on the expiry date. The American option permits early exercise while a European option does not. Both these types are traded throughout the world. European options are easier to analyze than American options and properties of an American option are frequently deduced from those of its European counterpart.
Options can be over the counter and exchange traded. Over the counter (OTC) options are private agreements between two parties and are tailor made to the requirements of the party buying the option. Exchange traded options are bought and sold on an organized exchange and are standardized contracts. Most exchange traded options are American style options.
Salient Features of Options:
Options have a fixed maturity date on which they expire; this is termed expiry date. European style options can be exercised only on the expiry date while American style options can be exercised on any day before the expiry date. The expiry date is also known as the exercise date, the strike date, or the maturity date.
The price at which the option is exercised is called the exercise price, or strike price. The exercise price is specified in the contract.
The person who writes the option is the option writer. The seller of an option is usually referred to as writer. The option writer is obliged to buy/sell the shares if the holder (buyer) exercises his option. The writer of a call option is generally bearish and writer of a put option is generally bullish. The writer of a call option must deliver the stock and the writer of a put option must buy the stock at the strike process if the option buyer or seller chooses to exercise his right. The profits/losses of options writers equal the losses/profits of the buyers. The maximum profit for the writer in case of an option unexercised is the premium received. The writer of a call has unlimited loss potential, while the writer of a put has limited loss potential. Option writing is risky and hence it requires a higher degree of understanding risk management ability and an active, regular presence in the derivatives market regularly.
The option premium is the price paid for the option by the buyer to the seller.