Option terminology

Options are a unique type of financial contract that have a throwaway feature. They give you the right but not the obligation to do something. You only use the contract if you want to. This contrasts with forward contracts, which oblige you to make a transaction at the pre-agreed price even if the market has changed and you would rather not. The fact that options provide a right but not an obligation means that users are able to obtain insurance against an adverse movement in the price of an asset rate, while still retaining the opportunity to benefit from a favourable price movement. At the same time, the maximum risk to the buyer of an option is the actual cost of the option.

An American call option is an asset that gives its owner the right to purchase a given “asset” (e.g. some shares or a quantity of currency):

• at a predetermined price (the exercise or strike price)

• on, or before, a stated date (the expiration or maturity date).

An American put option is similar except that it gives the right to sell the “asset”:

• at a predetermined price (the exercise or strike price)

• on, or before, a stated date (the expiration or maturity date).

In each option transaction there are two parties. The buyer of the option holds all the power and decides whether to buy, in the case of a call option, or to sell, in the case of a put option, the asset contained in the option contract. In contrast, the writer of the option stands ready to sell (if a call is exercised) or to buy (if a put is exercised). The maximum upside to the writer of the option is the premium received, and if they are forced to buy/sell it will only be because it is financially advantageous to the buyer.

The table below illustrates a typical equity option quotation:

These prices are generated using an asset price of $100, a standard deviation of 25% and interest rate of 5%, though what follows would apply regardless of the underlying assumptions.