Option Market

An option is contract that gives the holder (or buyer) the right (but not obligation) to buy or sell of specified quantity of underlying assets from or to the option writer (or seller) at specified price, within or at specified date.

According to the definition of the option, the option contract involves two parties: the buyer (or the holder) and the seller (or the writer) of the option contract. In an option contract, the writer of the option grants the buyer of the option the right, but not the obligation, to purchase from or sell to the writer, the underlying at a specified price within or at specified date. The writer grants this right to the buyer in exchange for a certain sum of money, which is called the option price or option premium. The specified price at which the holder can buy or sell the underlying assets is called exercise price or strike price. And the specified date in which the option buyer can exercise the right is known as expiration date or maturity date.

1.2 Types of Option

When an option grants the buyer the right to purchase the underlying from the writer (seller), is refers to as a call option or simply a call. On the other hand when an option grant the buyer to sell the underlying to the writer (or seller) is refers to as a put option or simply a put.

The timing of the exercising the option is an important characteristic of an option contract. According to the timing right of exercising the option, the option can be classified as American options and European option. The options that grant the right to exercise the option within or at expiration date is know as American option. On the other hands, the options that grant the right to exercise only at expiration date are known as a European option.

These two names refer to two different characteristics that only refer to the timing of exercising the option. They have nothing to do with the country where they created and exercised. Investors that buy the American option get the same benefits as investors that buy the European Option, plus those who buy the American Options are provided with more opportunities to exercise their option. As a result American Options are always worth at least as much as compare to the European Option.

Call and Put options are detachable marketable securities/ option, which can be separately traded. An option is created whenever an option writer sells a new option to an option buyer. Once after the option is created the buyer and the seller are bounded with the terms and conditions of the option. The things can be done with an option after it is created are:

¨ It may be traded either on an organized exchange or in the over-the-counter market at the price determined by the market mechanism.

¨ Exercise it to buy or sell the underlying securities or

¨ Hold it until it matures

1.3 specification of exchange traded option (terminologies)

The basic terminologies that have to be understood about the option are as follows:

Underlying assets: the assets (i.e. stock) under which the option created is known as underlying asset or simply underlying.

Premium: the price at which buying and selling of option take place is called option premium.

Expiration date: Each option is created for certain future period, this future date at which the option contract expired or matured is called expiration date. Normally options are short-term financial derivatives that have maturity period of less than one year.

Exercise price: the price at which the holder is entitled to buy from or sell to the underlying asset is called exercise price. The exercise price also called strike price.

Long position: the party or investors who buy and hold the option is known as having long position on option.

Short position: the party or investors who write or sell the option is known as having short position on option

Contract size: the numbers of underlying assets for which the contract is created or the number of underlying that the option entitled to buy or sell is known as contract size. Normally an option contract is for 100 shares of stock.

Position limit

Price quotes

1.4 Use of Option

Why does use options? It is the basic question, which makes clear the logic or benefits behind using options. Basically options are used for the following reasons:

To Manage Risk

Managing risk is one of the most important objectives of using derivatives. Option helps to manage two types of price risk; with the use of call option one can manage upside risk and with the use of put option one can manage downside risk associated with underlying assets.

To Transfer Risk

The derivatives instrument helps to transfer risk from one party to other. The holder of the option or buying the option means transferring risk to the writer or seller of the option.

To Generate Income

Options have its own intrinsic value, which is called option premium, or price of the option at which option can purchase and sale. This helps to generate income to the parties dealing with options transactions.

To Get Benefit of Financial Leverage

Creating financial leverage is one most important advantage of derivatives. Options make possible to manage downside and upside price risk at nominal cost. We will discuss more about the financial leverage in chapter 10.

To Use For Financial Engineering

Financial engineering is an art of creating new risk management structure for different types of risk, for this purpose the options are used in large extent. We will discuss more detail about it in chapter 10.