Business, Legal & Accounting Glossary

Definition: Option

Quick Summary of Option

Buying the rights to purchase an asset for a certain period of time. For example, a business may option an asset for 6 months for 10% of the sale cost. During this time they do not own the asset; however, the company that does own it is not allowed to sell it during this period.

What is the dictionary definition of Option?

Dictionary Definition

Options are financial instruments that are derivatives or based on underlying securities such as stocks.

  1. One of the choices which can be made.
  2. The freedom or right to choose.
  3. finance, legal A contract giving the holder the right to buy or sell an asset at a set strike price; can apply to financial market transactions, or to ordinary transactions for tangible assets such as a residence or automobile.

An option is a contract between a buyer and a writer (seller) of an underlying asset (such as a stock) where the buyer retains the right, but not the obligation, to buy or sell the underlying asset from/to the writer, at a given strike price, either on or before a predetermined expiration date. The buyer of an option pays the writer a premium to offset the risk the writer undertakes.

Full Definition of Option

  • Buying the rights to purchase an asset for a certain period.
  • For example, a business may option an asset for 6 months for 10% of the sale cost.
  • During this time they do not own the asset; however, the company that does own it is not allowed to sell it during this period.

An option is a financial derivative represented by a contract that one party receives from another giving buyer right to buy or sell the underlying security. A party which receives a contract is known as option holder and a party selling contract is called an option writer. An option holder (buyer) has right to buy or sell a financial asset or security at a strike price which is agreed upon on a specific date, which is also known as exercise date, or within a certain period of time. An option granting the right to buy an asset or security is known as a call option, whereas an option with right to sell is referred to as a put option.

Options are versatile securities with a number of uses. Options can be used as a hedging strategy, to guard against the risk of a price increase (for a buyer) or decrease (for a seller). A trader can use options to provide greater leverage and risk reduction, particularly for complex plays.

An option writer and an option holder often have contradictory views on the performance of security. Option writer waits for the price of a particular stock to go up to the desired level before he or she sells it. That will provide him or her with maximum profit. An option the buyer is of the opinion that the price of the stock will decline which would enable that person to secure a particular stock.

Option types

There are two major classes of option: a call option and a put option. A call option gives the buyer the right to buy the underlying asset from the writer, while a put option gives the buyer the right to sell the underlying asset to the writer. There are three major option styles: the American-style option, the European-style option, and the capped option. The American-style option, the most common style of option, allows the buyer to exercise the option at any time up until the expiration date. The European-style option is similar to the American-style option, however, the option cannot be exercised anytime before the expiration date, but just during a short period just before the expiration date. The capped option is the same as the European-style option except the option is automatically exercised when a cap strike price is reached (a positive cap for a call option, a negative cap for a put option). Other types of options include long term options (e.g. LEAPS) and exotic options (e.g. Bermuda option, lookback option, etc.).

There are various types of options that are available in the present-day financial market. These are as follows:

Exchange-Traded Options

Exchange-traded options are also known as listed options. Such options are traded in a regulated exchange. Exchange standardizes terms of the option.

Employee Stock Options

Here a stock option is granted to some specified staffs of a company.

Over-the-counter Options

Over-the-counter options(OTC) are stocks traded through a dealer network. These are also known as unlisted stock.

Options On Times Of Use

Option Valuation Models

There are a number of models that are used to determine the value of a particular option. These may be described as quantitative techniques and are based on risk-neutral pricing concept. Stochastic calculus is an integral part of these valuation models. Most often used option valuation models are the Heston model and the Black-Scholes model, which is a basic option valuation model. Heston model is a stochastic volatility model.

Following techniques are used in order to implement a particular valuation model. Those may be mentioned as below:

  • Analytic techniques
  • Monte Carlo models
  • The binomial tree pricing model
  • Finite difference models

Option Risks

At a primary level risks faced by an option is similar to that of any other security – changes in value over a period of time. Two major risks associated with options are pin risk and counterparty risk. Risks associated with options are normally more complicated and unpredictable than traditional securities.

Cite Term

To help you cite our definitions in your bibliography, here is the proper citation layout for the three major formatting styles, with all of the relevant information filled in.

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Modern Language Association (MLA):
Option. PayrollHeaven.com. Payroll & Accounting Heaven Ltd. April 21, 2021 https://payrollheaven.com/define/option/.
Chicago Manual of Style (CMS):
Option. PayrollHeaven.com. Payroll & Accounting Heaven Ltd. https://payrollheaven.com/define/option/ (accessed: April 21, 2021).
American Psychological Association (APA):
Option. PayrollHeaven.com. Retrieved April 21, 2021, from PayrollHeaven.com website: https://payrollheaven.com/define/option/

Definition Sources

Definitions for Option are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 29th March, 2020 | 10 Views.