INTRODUCTION

A financial option is a derivatives contract (a financial contract created to facilitate a different form of trade in an underlying instrument. Its value is in part derived from the value of the underlying.), which gives the buyer the right, but not the obligation, to trade in an underlying (a stock, bond, interest rate, etc) at a specified price (strike price) on a specific date (for European options), or at any time up to and including the specified date (for American options). The seller is under obligation to fulfil the contract if the buyer exercises his option.

Someone who buys an option or underlying is said to be long, whereas a seller is said to be short. As the buyer is obviously in a considerably stronger position than the seller, the buyer will have to pay for this privilege. This payment is called the premium.

A call confers the right to buy at the strike price, while a put confers the right to sell at the strike price. Although options can be used in combination with each other or with other financial instruments to give different payoff profiles, in isolation call buyers are speculating that the underlying will appreciate and put buyers are speculating that the underlying will depreciate. The seller is speculating that the underlying will move in the other direction, remain at the same price, or move in the buyer’s direction, but not enough to offset the premium the seller receives.

To give a brief example, assume a stock is trading at $100: a call option at the $120 strike price could be $5. If the underlying expired above $120 the buyer would exercise his option to buy, knowing he could immediately sell the underlying back for more. For each $ above $120 the underlying was trading, he would make an extra $1. However, to be in profit overall the underlying would have to be trading at $125 or over to compensate for the $5 premium paid originally. If the underlying finishes below $120, the buyer will let his option expire, knowing that it would be cheaper just to buy the underlying than to exercise his option to buy it at $120. In this case his loss would be his original $5 premium. Compare this to someone who buys the underlying. Though the underlying buyer would be in profit if the underlying finished this period anywhere above $100, he would lose $1 for each $ the underlying depreciated. If for some catastrophic reason the underlying went to $0, the buyer would lose his entire $100 investment.

This standard type of option, involving a basic call or put, is known as a vanilla option. There are also exotic options, which have more complex aspects and are generally not publicly traded. (hence they are excluded from
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