Options are contingent claims that can be exercised under specific conditions. By contingent it means two things:
- Although the holder may have the right to exercise the option, its exercise, under economic rationality, depends upon the observation of a certain set of conditions.
- The value of the option also depends on the observation of the same set of conditions.
Among the conditions established in the contract there are a certain number of characteristics that should always be specified:
- The underlying asset on which the option is built
- The maturity date of the option, that is, the final date when the option holder may exercise his right
- The exercise (strike) price for which the holder has the right to buy or to sell the underlying asset to the option writer
- The style of the option (if the option is American style, the holder can exercise the option at any moment in time until maturity, and if the option is European style, the holder can only exercise his right at maturity)
- The unit of trade, that is, the quantity of underlying asset that is under one option contract.
Options can be traded in options’ exchanges or over-the-counter (OTC). When options are traded in an exchange under a set of regulations, they are called traded options. Traded options are standardized contracts where the main contract specifications are standardized and not customized.
Among the main options exchanges in the world we have the Chicago Board Options Exchange (CBOE), the American Stock and Options Exchange (Amex), the Philadelphia Stock Exchange, the NYSE Euronext Liffe, and the Eurex (the last two in Europe).
There are two option types: calls and puts. A call option gives the holder the right, but not the obligation, to buy a certain asset by a specified priced, on or until a certain date. A put option gives the holder the right, but not the obligation, to sell a certain asset by a specified priced, on or until a certain date.
For instance, in NYSE Euronext Liffe, one equity call option contract on British Airways entitles the holder the right to buy 100 British Airways shares until maturity by a specified price. These NYSE Euronext Liffe equity options are American style.
In CBOE, an equity put option contract on General Motors conveys the holder with the right to sell 100 General Motors shares until maturity by a specified price. These options are also American style.
When the option is traded the option buyer pays a specified amount to the option seller called premium. The premium is then the amount of money that ties the option seller to the counterpart liability if exercised by the option buyer.
When options are trade OTC, they are called OTC options and contract specifications can differ and contract characteristics can be customized. We may set a different exercise price, or a different maturity date, for instance. We find traded options on a wide range of products and instruments, such as shares, bonds, stock indices, currencies, futures contracts, etc.
Although it is common to refer that the first reference to options is found in the biblical description of the Jacob and Rachel love story, in fact, the first piece of financial literature on the subject is found in Joseph de la Vega, a Portuguese Jew, living in Amsterdam in the XVII century.
After escaping from Portugal to avoid the Portuguese Inquisition, and after being familiar with the stock and options trading activity, he wrote a book called Confusion de Confusiones where options and its trading is carefully explained.
With the seminal papers of Black and Scholes (1973), Mer ton (1973), and Cox et al. (1979) option valuation became one of the major achievements in finance. Today, option theory is a fundamental base in helping the development of the financial industry, supporting the creation of new financial instruments and serving the valuation of companies and projects.