OPTIONS (Basics about Options)

The first Accounting for Equities class I attended years back when I was in college pricked my curiosity to research more and write about options. Nowadays, many investors’ portfolios include investments such as mutual funds, stocks and bonds. But the variety of securities you have at your disposal does not end there. Another type of security, called an option, presents a world of opportunity to sophisticated investors.
An option is a very common term in finance. It refers to a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike). The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset, commonly a stock(share), a bond, a currency or a futures contract, plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset.
An option which conveys the right to buy something at a specific price is called a call; an option which conveys the right to sell something at a specific price is called a put. The reference price at which the underlying asset may be traded is called the strike price or exercise price. The process of activating an option and thereby trading the underlying asset at the agreed-upon price is referred to as exercising it. Most options have an expiration date. If the option is not exercised by the expiration date, it becomes void and worthless.
In return for assuming the obligation, called writing the option, the originator of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised.
An option can usually be sold by its original buyer to another party. Many options are created in standardized form and traded on an anonymous options exchange among the general public, while other over-the-counter options are customized ad hoc to the desires of the buyer, usually by investment banks .
Every financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. Options usually contain the following specifications:

• whether the option holder has the right to buy (a call option) or the right to sell (a put option)
• the quantity and class of the underlying assets
• the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise
• the expiration date, or expiry, which is the last date the option can be exercised
• the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount
• the terms by which the option is quoted in the market to convert the quoted price into the actual premium – the total amount paid by the holder to the writer

Types of options      
Exchange-traded options
Exchange-traded options/listed options are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled upon fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options include:

• stock options
• bond options and other interest rate options
• stock market index options or, simply, index options and
• options on futures contracts
• callable bull/bear contracts

Over-the-counter
Over_the_counter options/dealer options are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include:

1. interest rate options
2. currency cross rate options, and
3. options on swaps or swaptions

Option styles
Naming conventions are used to help identify properties common to many different types of options. These include:

• European option – an option that may only be exercised on expiration.
• American option – an option that may be exercised on any trading day on or before expiry.
• Bermudan option – an option that may be exercised only on specified dates on or before expiration.
• Barrier option – any option with the general characteristic that the underlying security’s price must pass a certain level or barrier before it can be exercised.
• Exotic option – any of a broad category of options that may include complex financial structures.
• Vanilla option – any option that is not exotic.

Advice to potential investors
Despite what anybody tells you, option trading involves risk, especially if you don’t know what you are doing. Because of this, many people suggest you steer clear of options and forget their existence.
On the other hand, being ignorant of any type of investment places you in a weak position. Perhaps the speculative nature of options doesn’t fit your style. No problem – then don’t speculate in options. But, before you decide not to invest in options, you should understand them. Not learning how options function is as dangerous as jumping right in: without knowing about options you would not only forfeit having another item in your investing toolbox but also lose insight into the workings of some of the world’s largest corporations. Whether it is to hedge the risk of foreign-exchange transactions or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another.