An Introduction to Options

An option is a contract between two parties by which party A grants party B the right to buy from or sell to A, at B's discretion, a given asset at a fixed price until a fixed date after which any rights or obligations expire. The party having the discretionary right to buy or sell is the buyer of the option (in this case, B), and the party granting the right is the seller, or writer, of the option. An option to buy is known as a call option, and an option to sell as a put option. The fixed price specified in the option contract is termed the exercise or striking price, and the fixed date the expiration date. A European option is one which can only be exercised on the date when the option expires; an American option can be exercised at any time up to and including the expiration date. Though there are many different types of underlying asset on which an option could be based, it is options written on ordinary shares quoted on the Stock Market which have been of most interest. This has been greatly enhanced in recent years by the creation of organised markets for options in the main financial centres of the world. The first part of this paper considers the practical aspects of options and the main features of an organised options exchange. The second part of the paper concentrates on introducing option pricing theory in a simplified form. Finally, some of the many and varied possible applications of options and option pricing theory are briefly reviewed.