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Options are such derivative financial instruments that do not bind the option holder into a firm commitment. Options in fact provide the right to the option holder to exercise or not to exercise such rights as options.
Option Holder: One who, holds the right to buy or sale
Option Writer: One who, provides the right
Example
X and Y enter into an agreement where X will have the right to purchase 1,000 equity shares in NJ Ltd. at a price of ` 32 per share on 01.01.2011.
In the above example, the contract between X and Y is an option contract where X is an Option Holder and Y is an Option Writer. The underlying asset in the contract is equity shares in NJ Ltd.
This derivative contract is known as “Call Option” because it provides a right to the option holder to purchase. The exercise price or the strike price is ` 32 per share. The maturity date of this option is 01.01.2011. On the date of maturity the option holder, i.e., X has a right and not an obligation to buy such equity shares. If X however, exercises his right to buy then Y will be under obligation to sell.
Therefore, the option holder is always at a benefit. For sake of such benefit the option holder has to pay option premium to the option writer. Such premium is payable irrespective of whether the option is exercised or not.
American Options V/s European Options
If an option can be exercised on any day up to the expiry date (in other words on or before the expiry date) then such option is known as “American Option”. Where an option can be exercised only at its maturity or expiry date, then such option is known as “European Option”.
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