– Options are contingent claims, payoffs to an option depend on what happens to another value or cash flow often of another security.
– A call option allows one to purchase (call) another security or asset at a fixed price for a fixed period of time.
– The shares that can be purchased are known as the underlying assets for the option.
– The price the option allows you to purchase the shares is called a striking or exercise price.
– The final date you can exercise the option is known as the expiration date.
– With respect to when options can be exercised there are two types; European, which can only be exercised at expiration; and American, which can be exercised any time before or at expiration.
– When an option can be exercised profitably it is said to be in the money, when it cannot it is out of the money.
– On option owner (holder) need not exercise the option if he chooses not to do so.
– The issuer of the option is often termed the option writer. Rarely are options ever exercised in the sense of shares trading hands, usually its just money. This minimizes transaction costs.
– If the writer actually owns the underlying securities, the option is called a covered option or a covered call.
– If the value of the underlying security is less than or equal to the striking price the exercise value of the option is zero.
– Another type of option is a put. Allows the holder to sell something at a fixed price for a fixed period of time.
– Puts have positive exercise value to the holder when the underlying assets value is less than the striking price.
– Other combinations of puts/calls are formed (spreads, strips, straddles, hedges, butterflies) in complex transactions so as to generate a particular risk-return exposure to the holder or writer.