In a broad sense, an option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions. Thus, an option is a contingent claim. More specifically, it is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specific period of time.
The option to buy an asset is known as a call option, and the option to sell an asset is called an exercise price or a strike price. The asset on which the put or call option is created is referred to as the underlying asset. Depending on when an option can be exercised, it is classified on two categories,
• European. When an option is allowed to be exercised only the maturity dates, it is called a European option.
• American. When the option can be exercised any time before its maturity, it is called an American option.
When will an holder exercise his right? He will exercise his option when doing so provides him a benefit over buying or selling the underlying asset from the market at the prevailing price.
There are three possibilities,
1. In the money. A put or a call option is said to in the money when it is advantageous for the investor to exercise it. In the case of in the money call options, the exercise price is less than the current value of the underlying asset, while in the case of the in the money put options, the exercise price is higher than the current value of the underlying asset.
2. Out of the money. A put or a call is out the money if it is not advantageous for the investor to exercise it. In the case of the out of the money call option, the exercise price is higher than the current value of then underlying asset, while in the case of the out of money put options, the exercise is lower than the current value of the underlying asset.
3. At the money. When the holder of a put or a call option does not lose or gain whether or not he exercise his option, the option is said to be at the money. In the case of the out of the money options the exercise price is equal to the current value of the underlying asset.
Options do not come free. The involve cost. The option premium is the price that the holder of an option has to pay for obtaining a call or a put. The price will have to be paid, generally in advance, whether or not the holder exercises his option.