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OPTIONS

© Naeem Akhtar

An option is an agreement between two parties whereby one party (the option holder) has the right to perform a specified transaction having specified terms with the other party (the option issuer). Options arise in many fields. For example, in real estate, the holder of a property might issue an option to a prospective buyer allowing the buyer to purchase the property any time during the next three months at a specified price.

In finance, options are a type of derivative instrument. They are traded on exchanges as well as over the counter. They are linked to a variety of underliers including stocks, baskets of stocks, bonds, currencies, futures, swaps and commodities. While financial options come in many forms, there are two basic types:

1)A call option gives the holder the right to purchase a specified quantity of the underlier at a specified strike price by a specified expiration date. 2)A put option gives the holder the right to sell a specified quantity of the underlier at a specified strike price by a specified expiration date.

For example, an issuer might sell a call option granting the holder the right to purchase 100 shares of a certain stock at $50 each by a specified expiration date. If, on the expiration date, the stock were trading at $47, the holder would not exercise the option because there would be no sense in paying $50 for a stock that is worth $47. If, on the other hand, the stock is trading at $54, the holder would exercise the option, purchasing 100 shares worth a total of $5,400 for just $5,000.

Because the holder of such an option must pay the issuer a premium to purchase the option, he stands to lose that premium should the option expire worthless. However, that is all the purchaser stands to lose. His potential profit from purchasing the option is unlimited because there is (in theory) no limit to how much the underlying stock might appreciate during the life of the option.