Options Trading Defined:
Options are forms of derivative financial instruments that establish a contract between two parties who are concerned with the buying or selling of an asset at a distinguished reference price. The buyer of an option gains the right, but not the direct obligation, to engage in a specific transaction on the asset, while the seller will incur the obligation to fulfill the transaction if it is requested by the buyer.
The price of an option contract is derived from the difference between the reference price and the value of the underlying asset—typically options are attached to the buying and selling of stocks, bonds, futures contracts and currencies. In addition to the price of the underlying asset, option contracts are also attached with a premium based on the time left until the contract expires.
An option contract conveys the right to purchase something referred to as a call and the right to sell something known as a put. The reference price at which the underlying asset may be traded is referred to as the strike price or the exercise price. The process of activating an option and trading the underlying asset at the agreed-upon price is referred to as exercising.
The majority of options possess expiration dates; if the option is not exercised by the expiration date, it becomes worthless and is rules void.
The majority of options are created in standardized forms and traded on options exchanges among the general public, while other options are customized to the desires of the buyers based on an ad hoc basis—typically these options are delivered to an investment bank through an over-the-counter process.
Contract Specifics of Options
Every option contrast is an agreement made between two counterparties with the terms of the option specified in a term sheet. Option contracts may be complicated; however, the agreements laden in the contract typically contain the following stipulations and specifications:
Whether the holder of the option has the right to exercise a call option or the right to sell (a put option).
The quantity and class of the underlying asset. For example, the term sheet will specify the name of the company and the quantity of the shares.
The strike price, which is the specific price at which the transaction will be finalized and occur upon exercise.
The expiration date, which is the last date the option, can be exercised.
The settlement terms of the agreement, for example whether the writer must deliver the asset on exercise or if a tender equivalent to the cash amount is permissible.
The terms by which the option may be quoted in the market to convert the quoted price into the actual premium, meaning the total amount paid by the holder to the writer of the option agreement.