What are options?
An option contract refers to a derivative contract in which the owner of the contract has the right but not an obligation to buy or sell an underlying asset. The underlying asset could be a stock, commodity or currency. The owner of the option contract can buy or sell the underlying asset at a specified strike price. The option can be exercised on or before a specified date.
Understanding Call and Put Options
A call option refers to an option contract in which the owner of the contract has the right but not the obligation to buy the underlying asset at the strike price on or before the specified time period.
When an investor buys a call option, he is expecting the price of the underlying asset to go above the strike price before the contract expires. If the price of the asset moves above the strike price before the expiration of the contract, then the owner of the contract can buy the underlying asset at the strike price and sell it in the open market at a higher price. The profit would be the difference between the market price and the strike price less the option premium.
A put option on the other hand refers to a option contract in which the owner has the right but not the obligation to sell the underlying asset at the strike price on or before the specified time period.
The buyer of the put option contract pays a premium to the writer of the option. The buyer of the put option expects the price of the underlying asset to fall below the strike price before the contract expires. His motive could be to profit or just hedge his position.
Where are Options Traded?
Options can be traded either through an exchange or over the counter (OTC). Generally, stock options are traded on an exchange. Options traded on a exchange are settled through a clearing house and therefore there is no counterparty risk.
Options can be classified on the basis of the dates on which the option may be exercised. Majority of the option contracts are either European or American style options. Generally, these options are referred to as “vanilla options.”
A European option may be exercised only at the expiration date of the option. For example, if you buy a European call option on a stock X, strike price $20 and expiration data May 20, 2013. Now even if the price of stock X exceeds $20 before the expiration of the contract, the owner of the contract cannot exercise the option before May 20, 2013.
On the other hand, in an American option, the owner can exercise his right to buy or sell the underlying asset at any time before the expiration date. Therefore in the above example, if the price of stock X exceeds the strike price on May 10, 2013 i.e. 10 days before the expiration of the contract, the owner of the option contract can still exercise the contract.
Majority of the options contract traded are either European or American.
However, there are also other option styles. These options are generally referred to as “exotic options.”
Exotic options are different from vanilla options in terms of the underlying asset or the payoff calculation. Generally, exotic options are traded on the OTC market unlike vanilla options, which are mostly traded on an exchange.
The different types of exotic options include Barrier Options, Compound Option, Binary Option, Bermudan Option and Rainbow Option among others.