Option Essay ⋆ Business Essay Examples ⋆ EssayEmpire

In the finance world, an option is a contract between two parties when one party grants the other the right to buy/purchase a specific asset at a particular price within a particular time period. Alternatively, the contract may grant the other party the right to sell a specific asset at a particular price within a particular time period. The party who has received the right but has no obligation and instead has the right of decision to make (buy/sell in the case of a call or put option) is known as an option buyer or option holder. The party who has sold the right and is under the obligation to respond to the buyer’s decision is known as the option writer or option issuer. The price at which options are exercised is known as the strike price or exercise price. The option buyer pays an option price to the option seller known as an option premium. An option premium is not refundable even when an option is not exercised. Options can take many forms, such as the following:

Call Option: A call option gives the option buyer the right to buy a specific asset on a specific date for a specific price. The option seller is under an obligation to fulfill the contract, that is, to sell, and he/she is paid for an option premium by the option buyer. A call option can be long call or short call. A long call is when the trader who believes that the stock price will increase might buy the call option rather than buy the stock. If the stock price increases over the exercise price of the call option by more than the premium paid, he/she will get a profit. On the contrary, if the stock price decreases, he/she will not use the call option and buy the stock from the market and lose the amount of premium. A short call is when the trader who believes that the stock price will decrease might short sell the stock instead of selling a call option.
Put Option: A put option gives its holder, that is, the option buyer, the privilege or right to sell a specific asset by a specific date for a specific price. The option seller is under an obligation to fulfill the contract, that is, to buy, if the option buyer is ready to sell. The option writer charges the option premium initially for the same. The put option can be long put or short put. A long put is when the trader who hopes that the stock price will decrease can buy the put option. If the stock price decreases below the exercise price by more than the option premium paid, then the trader would get a profit. If the stock price increases, he/she will not exercise the put option and lose the option premium being paid by him/her. A short put is when the trader who hopes that the stock price will increase can buy the stock instead of buying the put option. If the stock price increases, a short put would give him/her profit, and vice versa.
American Option: An option, either call or put, that can be exercised even before maturity/expiration date is called an American option.
European Option: An option, either call or put, that can be exercised only on the maturity/expiration date is called a European option.
Bermuda Option: An option that can be exercised only on few specific dates prior to maturity is known as a Bermuda option.
Preference Option: In this option, the option buyer gets a privilege to designate the option either as a call option or put option.
Average Rate Option: This is the arithmetic average of the spot rate during the life of the option. It is the rate that is considered at the time of maturity instead of the spot rate. This rate can be applied to call as well as put options.
Compound Option: This is the option on an option. It can be a call on a call or a call on a put or a put on a put or a put on a call.

An option is a derivative instrument that is used to hedge risk. Both the option buyer and option writer can protect themselves from an uncertain situation. Hedging is being done by resorting to the purchase or sale of options. Speculators use options for speculative purposes. Normally, the speculator enters into vertical spread on call combinations, horizontal spread on call combinations, or diagonal spread on call combinations, or straddles and strangles. Basically, there are three situations in option exercises. The first is at-the-money: this is the situation in which the strike price is equal to the spot rate on the expiration date. The second is in-the-money: in the case of a call option, an in-the-money situation is confronted when the strike price is lower than the spot price. Conversely, in the case of a put option, an in-the-money situation occurs when the spot price is lower than the strike price. The third situation is out-of-the-money: this is the opposite of the in-the-money situation. In the case of a call option, an out-of-the-money situation is confronted when the spot price is lower than the strike price. Conversely, in the case of a put option, an out-of-the-money situation occurs when the strike price is lower than the spot price.

Option prices depend on a number of factors such as degree of volatility, interest rate differential, expiration date, change in forward rate, change in spot price, and so forth. It is said that an option is “a double-edged sword to hedge against risk.”

Bibliography:

Roger C. Charke, Options and Futures: A Tutorial (Research Foundation of the Institute of Chartered Financial Analysts, 1992);
John C. Cox and Mark Rubenstein, Options Markets (Pearson Prentice Hall, 1985);
David A. Dubosky, Options and Financial Futures: Valuation & Uses (McGraw-Hill, 1992);
Peter H. Ritchken, Options: Theory, Strategy, and Applications (Scott, Foresman, HarperCollins 1988);
Vyuptakesh Sharan, International Financial Management (Prentice Hall, 2001);
Hans R. Stoll and Robert E. Whaley, Futures & Options: Theory & Applications (Southwestern, 1993).

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