An option gives its holder the right to buy or sell an asset at a price that is either fixed or calculated according to a pre-arranged formula.
The buyer of an option is not obliged to either buy or sell the underlying asset. The originator of an option, called the option writer, is obliged to carry out their side of the transaction, should the holder of the option want them to.
The underlying asset is most commonly a financial security (e.g. shares or bonds), a commodity (e.g. a fixed quantity of a metal) or linked to a financial index.
An option which gives the buyer the right to buy an asset is a call option. An option which gives the buyer the right to sell an asset is a put option. The asset the option is called the underlying asset. The price at which the underlying security is to be bought or sold is called the strike price or exercise price.
Options are closely related to futures contracts, but they give a holder the upside without the downside risk. Because this means that the writer takes the risk but foregoes the opportunity to profit. This means the writer needs to be compensated for taking the risk, and they are worth more to the holder.
Most options traded on exchanges are not settled by delivery (actually transferring the underlying asset) but by a payment of the value of the option at expiry. This value is either zero (if the option is at-the-money or out-of-the-money) or the amount by which the option is in-the-money.
Option value may also exist outside financial instruments, intrinsic in contracts or businesses. These are called real options.
Vanilla and exotic options
The most common types of option are the simple American and European options which have fixed strike prices and expiry dates. These are common, mathematically simple, and comparatively well understood. They are often referred to as vanilla options.
Asian options are somewhat less common and have strike prices based on the average price of the underlying over a pre-determined period. More complex types of options are hugely varied and are collectively referred to as exotic options.
The valuation of an option requires the use of more complex models than the underlying securities. The value can be regarded as broken down into intrinsic value and option value — the latter being what is hard to value. The commonest way of valuing options is the Black-Scholes formula.