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WHAT IS OPTION IN FINANCE

An option in finance is a security contract that belongs to a group of financial instruments called derivatives. This contract has its defined terms and condition that governs the ability of the buyer to buy or sell underlying financial securities such as stocks. Unlike the future, the buyer can buy or sell his underlying asset whenever he or she feels like. That means that the buyer is granted the right but not an obligation on his financial instruments.

History of option in finance

Similar contracts such as options can be traced back to ancient times. The most reputed option buyer was called Thales of Miletus, who was an ancient Greek philosopher and mathematician. Thales of Miletus was such a financial nerd that during a certain olive harvest season, it was expected that the harvest would be higher than before which made him exercise his rights of options by renting olive presses out at a far higher price.

A famous book "Confusion of Confusions" published in 1688, describes how "opsies" were traded on the Amsterdam stock exchange with a view of limited risks and unimaginable profitable gains.

During the reign of William and Mary in London in 1690s, Refusals and puts became popular trading instruments. In nineteen century America, privileges were sold with shares offered by some specialized dealers of both calls and put with fixed market prices depending on the days the privileges options were bought. However, these options were not traded in secondary markets due to its three month's expiry date upon the purchase.

The use of options in the real estate market gives the buyer the right to assemble huge pieces of land from different owners. While in the lines of credit field, potential borrowers are given the right to borrow money within the stipulated period. Today, many embedded options have been included in the bond contacts such as convertible bonds and callable bond options.

Characteristics of Options

Although the terms and conditions of options are clearly stated in the term sheet, some specifications contain in all the financial options. These specifications are;

Call and Put Option

This feature gives the holder of the option a right to buy or sell his option.

Strike Price

This is the price of the transaction that underlies the asset upon exercise; it is also termed as the exercise price.

Expiry date

This is the end date of the exercise of the option.

Settlement terms

These terms govern the thought whether the writer should tender equivalent cash amount or the actual asset that is on exercise.

Market Terms

These terms are quoted in the market to give an obligation to the holder to pay the total amount to the writer.

Categories of Options

Options can be classified according to

  • Option rights
  • Underlying assets
  • Classification according to options rights

    There are two commonly known option rights. These option rights are call options and put options. A call option gives the buyer the right and no obligation to buy the underlying option at a specific date and price while a put option gives the buyer the right but not obligation to sell an item at a particular price and date.

    Classification according to underlying assets

    There are different types of option under this category. Some of the options are

    Equity option in finance

    These are the common type of equity derivatives in which the buyer is given the right with no obligation to buy or sell a quantity of stock at a strike price before its expiry date.

    Index option in finance

    This is the type of option which gives the holder the right but not obligation to buy or sell an underlying value of an index. Some of the index value is the Standard and Poor's 500. Index options are European-style options that are settled with cash.

    Commodity Option in finance

    This is a financial option that permits the buyer to sell or buy an underlying value of an asset in the form of a commodity at a designated price at a certain date. These commodities can be agricultural products, precious metals or oil.

    Currency option in finance

    This type of option gives the holder the right, but not obligation to buy or sell a particular currency before or at a given date at a specified exchange rate.

    Bond option in finance

    This is a contract that gives the buyer the right but not the obligation to sell or buy a bond at a specific rate and date. This type of option is typically traded over the counter (OTC).

    Future Option in finance

    This is an option whose contract gives right but not the obligation to the holder to buy or sell an underlying asset in the form of a future at a particular price and date.

    Benefits of Financial option in finance

    Investing in financial options can be of great importance such as

    Increased Cost efficiency

    Since options have high leveraging power, option investor can acquire similar position as that of a stock which has huge cost savings. However, this might not be as simple as said. The financial option investor has to carefully buy the right call that is equivalent to a stock position. Not only does this stock replacement viable but also cost effective and practical.

    Higher Returns

    Options have a huge payoff, which gives the investor the motivation to invest in these financial instruments. However, when the investment doesn't go your way, this type of investment can be a heavy toll that can make you lose the whole investment.

    Option in finance is less risky

    Unlike owning equities, buying options can be associated with huge risks. However, with a good investment plan, you will find options a bit less risky since they require a small financial commitment. Options are also dependable hedge form that makes it a good choice overstocks.

    Options offer more strategic Alternatives

    Option is a flexible tool that offers many investment alternatives to the investor. This gives the investor many ways that he or she can attain similar useful investment goals.

    Disadvantages of Options

    Options have multiple advantages. However, as an options investor, it is good also to understand the other side of the coin. Horrendous high taxes and commissions, wide swings in portfolio value and uncertain gains are some of the demerits associated with this type of financial instrument.

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