Option (finance)

In the world of finance, an option is a contract that grants the owner, known as the holder, 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, depending on the type of option. This right can be exercised either to buy or sell the asset or instrument. Options may be obtained in a variety of ways, the most common of which are by purchase, as a form of remuneration, or as part of a sophisticated financial transaction. Therefore, they are also a kind of asset and have a valuation that may rely on a complicated connection between the value of the underlying asset, the amount of time left until the option expires, the volatility of the market, and a variety of other variables. Options may be traded between private parties in over-the-counter (OTC) transactions, or they can be exchange-traded in live, orderly markets in the form of standardised contracts.

This right may be exercised either before or after the date indicated in the contract. On the day that an option is offered, the striking price may be determined by reference to the spot price (market price) of the underlying securities or commodity. Alternatively, the strike price may be established at a discount or a premium relative to the current price. In the event that the holder "exercises" the option, the issuer is under the associated duty to carry out the transaction (either to sell or to purchase). A call option is one that gives the holder the right to purchase at a certain price, while a put option is one that gives the holder the right to sell at a certain price. Both of these options fall under the category of financial derivatives.

An option may be granted to a buyer as part of another transaction (such as a share issuance or as part of an employee incentive programme), or the buyer may pay a premium to the issuer in exchange for the option. Alternatively, the issuer may choose to give the option as part of another transaction. To execute a call option, the strike price would typically need to be lower than the current market value of the underlying asset. Conversely, to exercise a put option, the strike price would typically need to be higher than the current market value of the asset. When an option is exercised, the holder of the option must pay an amount equal to the "strike price" of the asset being purchased in addition to any premium that must be paid to the "issuer" of the option. If the option's expiry date comes and goes without the holder exercising the option, the option is said to have expired, and the premium that was paid to the issuer by the holder is considered to have been lost. In any event, the premium is revenue for the issuer but, in most cases, a loss in terms of capital for the option holder.

Depending on the option, the owner of an option may resell that option to a third party in a secondary market via either an over-the-counter transaction or on an options exchange. This can take place in any of these two ways. The market price of an option written in the American style often tracks that of the underlying stock very closely. The market price of the option is calculated as the difference between the current market price of the underlying stock and the strike price of the option. There are a number of factors that could cause the actual price of the option on the market to fluctuate. One of these factors is a significant option holder who needs to sell the option because the expiration date is getting closer and they do not have the financial resources to exercise the option. Another factor is a buyer in the market who is attempting to amass a large option holding. The ownership of an option does not, in most cases, entitle the holder to any rights associated with the underlying asset, such as voting rights, nor does it entitle the holder to any income from the underlying asset, such as a dividend. These are examples of rights that are typically not conferred by ownership of an option.