Option Valuation

Meaning

An option is an investment alternative among various alternatives available in the world of investment. It is a contract between two people where in one person grants the other person the right, but not the obligation, to buy or sell a specified asset at a specified (predetermined) price on or before a set expiration date. Between any two parties involved in the contract, the party receiving the right to buy or sell a specific asset is called an option buyer and the person giving the right to sell or buy the asset is called an option seller or option writer.

An option is probably the most popular derivative security in the world of investment. It is derivative because it derives its value from an underlying security (security for which the option has been written) such as stock, a bond etc.

Options, in the securities industry, are marketable security. They can easily be bought and sold in the stock exchanges (organized stock exchanges and over the counter market). So the option owner has the right to sell the option and any other investors can invest in the option. An option buyer pays an option writer a premium fro granting the option. After options have been created, they can be traded in determined premiums (or prices) that fluctuate continuously. The party who buys an option is long the option and writers are said to be short the option.

Characteristics of option

Ø       Expiration date: - An option is a finite life instrument; therefore, it has a certain maturity period. The option expires after its maturity period and the maturity date is the expiration date of the option.

Ø       Exercise (strike) Price: - It is a pre-specified price at which the option buyers buy or sells the underlying security. Exercise price is determined at the time of option contract and its also called strike price. The strike price generally set at or near the prevailing market price of the stock at the time the option is issued.

Ø        Exercise of option: - It is the act of buying or selling of securities for which the option has written.