Options are a form of derivative; which basically means they derive their value from an underlying asset. In an options contract the underlying asset is the asset which is specified in the transaction the holder has the right to carry out. For example, a contract might give the holder the right to purchase stock in Company X, in which case Company X stock is the underlying asset.
The term underlying security is also commonly used, but both terms refer to the same thing. There's a range of financial instruments that can be the underlying asset in an option. Stock is the most commonly used asset, but bonds, indices, foreign currencies, commodities, or futures can all be used too.
There are even basket options, in which the underlying asset is a collection of different assets. The strike price is the price at which the specified transaction is to be carried out at should the holder choose to exercise their option. Strike price is the term most commonly used, but it can also be known as the exercise price.
The expiration date of an option is, quite simply, the date on which the contract will expire. Options are typically relatively short term and last just a few weeks, although they can also last for a few months or up to a year. If the expiration date passes and the holder hasn't chosen to exercise their option, then the contract expires worthless.
There are actually many different types of options, because they can be classified in a variety of different ways. In a very broad sense though, they can be categorized based on whether they give the holder the right to buy or sell the underlying asset. In this sense, there are basically two main types; call options which give the holder the right to buy the underlying asset at the strike price, and put options which give the holder the right to sell the underlying asset at the strike price.
It should be noted that you don't have to actually own any of the underlying asset to buy a put option, but if you choose to exercise your option to sell the underlying asset you will, in theory, have to buy the underlying asset at that point. Please see our section on the Types of Options for further details on this.
Another way that options can be categorized is based on their exercise style. They can basically be one of two styles: American style or European style. These terms have nothing to do with anything geographical though. An American style option is one where the holder can exercise their option at any time during the term of the contract, up to and including the date of expiration.
A European style option is one where the holder can only exercise their option, should they wish to, at the point of expiration. American style options clearly offer much more flexibility to the holder, and because of this they are generally more expensive to buy. When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place.
They are physical settlement and cash settlement. Physical settlement is where the underlying asset is actually transferred between the buyer and the holder at the agreed strike price.
Cash settlement is where the holder receives a cash payment based on any profit they could effectively make through exercising their option. Please see Options Settlement for more details. When the writer of an options contract sells it to a buyer, the buyer makes a payment in order to purchase it. However, the amount that the buyer pays isn't the same amount that the writer receives. Options are typically bought and sold on the public exchanges, where the transactions are facilitated by market makers.
They basically exist to ensure that there's always a market for options contracts. If someone wishes to sell, and there is no buyer, then the market maker will act as the buyer and complete the necessary transaction. If someone wishes to buy, but there is no seller, then the market maker will act as the seller. Market makers make a small profit on each transaction.
Options contracts are listed on the exchanges with two prices: The bid price is the price you would receive for writing options contracts, and the ask price is the price you would pay for buying them. It's important to note that options contracts aren't just sold to buyers at the time of being written; holders of existing options contracts can also sell them to other buyers. Again, the seller would receive the bid price and the buyer would pay the ask price.
You can read more about the price of options here. To help you fully understand what an options contract is we have provided a couple of examples below, featuring some different characteristics. In relation to certain types of asset principally land , in many countries an option must be registered in order to be binding on a third party.
The option contract provides an important role in unilateral contracts. In unilateral contracts, the promisor seeks acceptance by performance from the promisee.
In this scenario, the classical contract view was that a contract is not formed until the performance that the promisor seeks is completely performed. This is because the consideration for the contract was the performance of the promisee.
Once the promisee performed completely, consideration is satisfied and a contract is formed and only the promisor is bound to his promise. A problem arises with unilateral contracts because of the late formation of the contract. With classical unilateral contracts, a promisor can revoke his offer for the contract at any point prior to the promisee's complete performance.
The promisor has maximum protection and the promisee has maximum risk in this scenario. An option contract can provide some security to the promisee in the above scenario. The promisor impliedly promises not to revoke the offer and the promisee impliedly promises to furnish complete performance, but as the name suggests, the promisee still retains the "option" of not completing performance. The consideration for this option contract is discussed in comment d of the above cited section.
Basically, the consideration is provided by the promisee's beginning of performance. Case law differs from jurisdiction to jurisdiction, but an option contract can either be implicitly created instantaneously at the beginning of performance the Restatement view or after some "substantial performance.
It has been hypothesized that option contracts could help allow free market roads to be constructed without resorting to eminent domain , as the road company could make option contracts with many landowners, and eventually consummate the purchase of parcels comprising the contiguous route needed to build the road. It is a general principle of contract law that an offer cannot be assigned by the recipient of the offer to another party. However, an option contract can be sold unless it provides otherwise , allowing the buyer of the option to step into the shoes of the original offeree and accept the offer to which the option pertains.
In economics, option contracts play an important role in the field of contract theory. In particular, Oliver Hart , p. From Wikipedia, the free encyclopedia. The examples and perspective in this article deal primarily with the United States and do not represent a worldwide view of the subject. You may improve this article , discuss the issue on the talk page , or create a new article , as appropriate. December Learn how and when to remove this template message. Competition, Entrepreneurship, and the Future of Roads.
Perillo, The Law of Contracts , p.