Options Contract: Overview & Types
An option contract is a derivative product that provides the buyer a right to buy/sell the underlying asset at a certain price at or during a specific maturity.
Two distinct kinds of option contracts exist: call options and put options. A call option gives the owner the right to buy the asset; a put option gives the owner the right to sell the asset.
Options contract has the following ingredients:
- Maturity
- Underlying Asset
- Strike Price
- Contract Amount
KEY TAKEAWAYS
- If the option buyer decide “to use” the option, underlying assets or cash is exchanged with respect to the conditions of the contract.
- The decision to use, or not to use is completely under the responsibility of the buyer; the seller does not have any right on this issue.
- Seller takes the liability premium (option price) for this obligation, and buyer pays this premium for the right.
Quick Facts About Options
- You don’t have to own options to sell them. You can sell (write) an option contract and it is created and sold to a new buyer.
- Option payoffs are zero-sum. Ignoring the commissions paid to the market maker, the total amount created by issuing an option is zero. The buyer’s profit (loss) is the seller’s loss (profit).
- Options are cheaper than underlying assets. Hence, they provide leverage.
- Whether it is American or European, the buyer can always exit her position by selling the option back anytime before maturity. Similarly a seller can always close her open position by buying one with same characteristics (strike and maturity).
Understanding Exercise
Options can be American or European, which determines how you can enact them. American options allow their holders to exercise the option on any date up to and including a final date called the expiration date. European options allow their holders to exercise the option only on the expiration date.
The names American and European have nothing to do with the location where the options are traded: Both types are traded worldwide.
The Bottom Line
An option is a contractual right giving its owner the right to buy or sell the underlying asset at a given price at or before a given date. The buyer pays for the option, and the writer deposits margin.
Exercise styles:
- European (exercise only at expiry)
- American (exercise at any time until expiry)
- Bermudan (American with restricted early exercise)
Markets:
- Exchanges (CBOE, CME, Intercontinental, NASDAQ OMX, BIST
etc) for standard options - Over-the-counter markets for non-standard options such as Asian
options, Bermudan options and other exotic options
Types by underlying asset:
- Index options
- Long Term Equity Anticipation Securities (LEAPS)
- Flexible exchange traded options (FLEX options)
- Currency options
- Interest rate options
- Commodity and energy options
- Options on futures
- Options on options