OPTIONS An option is a contract in which the writer of the option grants the

OPTIONS An option is a contract in which the writer of the option grants the

buyer of the option the right, but not the obligation, to purchase from or sell to the writer an asset at a specified price within a specified period of time (or at a specified date). The writer, also referred to as the seller, grants this right to the buyer in exchange for a certain sum of money, which is called the option price or option premium. The price at which the asset may be bought or sold is called the exercise price or strike

price. The date after which an option is void is called the expiration

date. As with a futures contract, the asset that the buyer has the right to buy and the seller is obligated to sell is referred to as the underlying.

When an option grants the buyer the right to purchase the underly- ing from the writer (seller), it is referred to as a call option, or call. When the option buyer has the right to sell the underlying to the writer, the option is called a put option, or put.

An option is also categorized according to when the option buyer may exercise the option. There are options that may be exercised at any time up to and including the expiration date. Such an option is referred to as an American option. There are options that may be exercised only at the expiration date. An option with this feature is called a European option. An option that can be exercised before the expiration date but only on specified dates is called a Bermuda option.

To illustrate the characteristics of an option contract, suppose that Patricia buys a call option for $2 (the option price) with the following terms:

1. The underlying is one unit of Asset X.

2. The exercise price is $60.

3. The expiration date is three months from now, and the option can be exercised any time up to and including the expiration date (that is, it is an American option).

FOUNDATIONS

At any time up to and including the expiration date, Patricia can decide to buy from the writer of this option one unit of Asset X, for which she will pay a price of $60. If it is not beneficial for Patricia to exercise the option, she will not. Whether Patricia exercises the option or not, the $2 she paid for the option will be kept by the option writer. If Patricia buys a put option rather than a call option, then she would be able to sell Asset X to the option writer for a price of $60.

The maximum amount that an option buyer can lose is the option price. The maximum profit that the option writer can realize is the option price. The option buyer has substantial upside return potential, while the option writer has substantial downside risk. The risk/reward relationship for option positions will be discussed later.

There are no margin requirements for the buyer of an option once the option price has been paid in full. Because the option price is the maximum amount that the investor can lose, no matter how adverse the price move- ment of the underlying, there is no need for margin. Because the writer of an option has agreed to accept all of the risk (and none of the reward) of the position in the underlying, the writer is generally required to put up the option price received as margin. In addition, as price changes occur that adversely affect the writer’s position, the writer is required to deposit addi- tional margin (with some exceptions) as the position is marked to market.