In finance, an option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction – that is to sell or buy – if the buyer (owner) “exercises” the option. The buyer pays a premium to the seller for this right. In options trading, An option which conveys to the owner the right to buy something at a specific price is referred to as a call; an option which conveys the right of the owner to sell something at a specific price is referred to as a put. Both are commonly traded, but for clarity, the call option is more frequently discussed.
Big part of options trading is the Options valuation. this is a topic of ongoing research in academic and practical finance. In basic terms, the value of an option is commonly decomposed into two parts:
The first part is the intrinsic value, which is defined as the difference between the market value of the underlying and the strike price of the given option.
The second part is the time value, which depends on a set of other factors which, through a multi-variable, non-linear interrelationship, reflect the discounted expected value of that difference at expiration.
Although options valuation has been studied at least since the nineteenth century, the contemporary approach is based on the Black–Scholes model which was first published in 1973.
Options contracts have been known for many centuries, however both trading activity and academic interest increased when, as from 1973, options were issued with standardized terms and traded through a guaranteed clearing house at the Chicago Board Options Exchange. Today many options are created in a standardized form and traded through clearing houses on regulated In options trading exchanges, while other over-the-counter options are written as bilateral, customized contracts between a single buyer and seller, one or both of which may be a dealer or market-maker. Options are part of a larger class of financial instruments known as derivative products, or simply, derivatives.
Options Trading Types
Options can be classified in a few ways.
According to the option rights
- Call option
- Put option
According to the underlying assets
- equity option
- bond option
- future option
- index option
- commodity option
According to the trading markets
- Exchange-traded options (also called “listed options”) are a class of exchange-traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the Options Clearing Corporation (OCC). Since the contracts are standardized, accurate pricing models are often available. Exchange-traded options trading, 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 contract
- Over-the-counter options trading (OTC options, also called “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:
- interest rate options
- currency cross rate options, and
- options on swaps or swaptions.