In finance, an option is a type of financial instrument classed as derivatives because they derive their value from an underlying asset. An option gives its holder the right, but not the obligation, to buy or to sell some asset (underlying) on or before the option's expiration at an agreed price, the strike price.
In return for granting the option, the seller collects a payment (the premium) from the buyer. Granting the option is also referred to as "writing" the option. In many cases the option can be sold only by its original buyer, and this is why the distinction between the term "seller" and "writer" is useful when describing options. It is the writer who is the particular seller who must make good on delivering (or receiving) the underlying asset or its cash equivalent, not any seller.
- A call option gives the buyer of the option the right but not the obligation to buy the underlying at the strike price.
- A put option gives the buyer of the option the right but not the obligation to sell the underlying at the strike price.
If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, a security (stock or bond), or a derivative instrument, such as a futures contract.
The theoretical value of an option is evaluated according to several models. These models, which are developed by quantitative analysts, attempt to predict how the value of an option changes in response to changing conditions. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other.
Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepaymentoptions are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.