An option relates to a contract drawn between a buyer and a seller which grants the purchaser of the given option the power, but not necessarily the obligation to purchase or sell a particular underlying asset prior to the expiration date of the option according to the agreed terms.
The options come in various types, and standard options which are also known as plain vanilla options are put options and call options. There are also distinctions in the characteristics of options between countries, for example, in Europe options can be exercised only at maturity, while American options at any stage of their lifespan.
This affects the value of the option, for example by the presence of dividends in the case of stock options, and renders American options more expensive than a European option with otherwise similar qualities.
Options are evaluated using a number of models, and the value is interpreted on the basis of how the intrinsic value of an option changes in response to varying conditions. The models allow for precision valuation in relation to the granting, owning, or trading of options which leads to improved quantification and management.
On the other hand, exchange-traded options come with standardized contract features, they also facilitate easy access to public or independent parties. These over-the-counter options are often traded by well-capitalized parties that agree on special trading and clearing arrangements.
Options may be completed as an individual contract between the option holder and the option writer, it can be freely designed. And the bulk of trade in options consists of standardized contracts that are carried out on futures exchanges such as CBOT in America. The standardization is aimed at boosting the liquidity of the options.
From the two basic forms of options, any number of other options can be created. Non-standard types of options are called exotic options, these include, capped options, rainbow options, Asian options and compound options among others. Convertible bonds incorporate the right to convert into shares and also the right to terminate.
There are terms that are synonymous with options and these include ‘in the money’ which points to an option whose market price of the underlying asset is higher than the strike or call price or alternatively the market price of the underlying asset is lower than the exercise or put price. While the amount on which the current price is better than the exercise price is called the intrinsic value of the option.
‘Out of the money’ points to an option that has no intrinsic value, a call option is out of the money when the market price of the underlying asset is less than the exercise price, while a put option is out of the money when the market price of the underlying asset is greater than the exercise price.