Understanding corporate finance: derivative contracts: options
An option contract differs from other sorts of derivative because it gives the holder a choice. Any option agreement gives the holder the right, but not the obligation, to buy or sell a specified underlying asset, on or before a particular date.
A call option confers the right (but not the obligation) to buy the underlying. A put option confers the right (but not the obligation) to sell the underlying.
The sale or purchase is often simply notional. For example, someone who buys a call option on the NASDAQ 100 index will not (normally) buy every share represented by that index if he or she exercises the option. Instead there would be a cash settlement based on the difference between the price specified in the option agreement (the strike or exercise price) and the value of the index at the exercise date.
An option contract will always include an expiry date, and may be defined as follows:
|Term||When option may be exercised|
|European (or European style)||Only on the expiry date of the option.|
|American (or American style)||On any business day up to and including the expiry date.|
|Bermudan||On any one of a number of specified dates.|
The rights acquired by the holder of an option have a value. So someone who enters into an option contract will almost always have to pay a premium in order to do so. The premium is normally payable at the start of the contract, although you may sometimes see option arrangements where the premium is paid in instalments over the life of the contract, or even rolled up and paid at the expiry date.
Working out how much someone should pay by way of premium - involves some complex mathematics. Some of the basic principles are explained at CFM13200.
Many types of standardised option contracts - over interest rates, currency, shares, bonds or commodities - are exchange-traded. Companies may also use over the counter (OTC) options.