Basic fundamentals of Options

Options are fundamentally different from forward and futures contracts. The term ‘option’ basically means a choice. In derivatives, the buyer of an option contract has the right, but not the obligation, to either buy or sell the underlying asset at an agreed upon price before a particular date. Futures and forwards on the other hand are commitments given by both parties to buy and sell the asset. The trader does not incur a cost while entering a futures or a forward contract, but to purchase an option contract he has to pay a fee (premium) to the seller of the option contract. (Note that we are talking about buying and selling the option contract and not about buying or selling the underlying asset). The seller of an option (a.k.a. Option Writer) receives cash up front, but has potential liabilities later.

Options may be traded in the OTC markets using customised contracts, or they may be traded on an exchange using standardised contracts. The contract can be physically settled or cash settled. Usually, exchange traded index options are cash settled.

There are 2 types of options –

• Call option – which gives the option buyer the right to ‘buy’ an underlying asset for a certain price and by a certain date.
• Put option – gives the option buyer the right to ‘sell’ the underlying asset for a certain price and by a certain date.

The price at which the underlying can be bought or sold under an option contract is called as the Strike Price and the date specified in the contract is known as the Expiry Date or Maturity Date.

The exercising of the options depends on the style of the option.

• American options can be exercised anytime during the tenure or even on the expiry date. Most exchange traded stock options are of this style. The premium for these types of options is higher as they offer more flexibility.
• European options can be exercised only on the expiry date. These options are mostly traded OTC. However, most exchange traded index options are of the European style.