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Published by: vinit_rini2000 on Feb 02, 2011
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In finance, an
is a contract between a buyer and a seller that gives the buyer the right—  but not the obligation—to buy or to sell a particular asset (the underlyingasset) at a later day at an agreed price. In return for granting the option, the seller collects a payment (the
)from the buyer. A
option gives the buyer the right to buy the underlying asset; a
optiongives the buyer of the option the right to sell the underlying asset. If the buyer chooses toexercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer maychoose not to exercise the right and let it expire. The underlying asset can be a piece of property,or shares of stock or some other security,such as, among others, a futures contract. For example,  buying acall optionprovides the right to buy a specified quantity of a security at a set agreedamount, known as the'strike price' at some time on or beforeexpiration, while buying a put optionprovides the right to sell. Upon the option holder's choice to exercisethe option, the party who sold, or wrote the option, must fulfill the terms of the contract.The theoretical value of an option can be evaluated according to several models. These models,which are developed byquantitative analysts, attempt to predict how the value of the option willchange in response to changing conditions. Hence, therisksassociated with granting, owning, or tradingoptions may be quantified and managed with a greater degree of precision, perhaps, thanwith some other investments. Exchange-traded options form an important class of options whichhave standardized contract features and trade on public exchanges, facilitating trading amongindependent parties.Over-the-counter  options are traded between private parties, often well- capitalized institutions that have negotiated separate trading and clearing arrangements with eachother. Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for examplereal estate optionsare often usedto assemble large parcels of land, and prepaymentoptions are usually included inmortgage  loans. However, many of the valuation and risk management principles apply across all financialoptions.
Contract specifications
Every financial option is a contract between the two counter parties with the terms of the optionspecified in aterm sheet. Option contracts may be quite complicated; however, at minimum, theyusually contain the following specifications:
whether the option holder has the right to buy (a call option) or the right to sell (a put option
the quantity and class of theunderlying asset(s) (e.g. 100 shares of XYZ Co. B stock)
thestrike price,also known as the exercise price, which is the price at which the underlying transaction will occur uponexercise 
theexpiration date, or expiry, which is the last date the option can be exercised
thesettlement terms, for instance whether the writer must deliver the actual asset onexercise, or may simply tender the equivalent cash amount
the terms by which the option is quoted in the market to convert the quoted price into theactual
 –the total amount paid by the holder to the writer of the option.
Types of options
The primary types of financial options are:
Exchange traded options
(also called "listed options") are a class of exchange tradedderivatives. Exchange traded options have standardized contracts, and are settled througha clearing housewith fulfillment guaranteed by the credit of the exchange. Since the
contracts are standardized, accurate pricing models are often available. Exchange tradedoptions include:1.stock options,
stock market index optionsor, simply, index options and
(OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTCoption are unrestricted and may be individually tailored to meet any business need. Ingeneral, at least one of the counterparties to an OTC option is a well-capitalizedinstitution. Option types commonly traded over the counter include:1.interest rate options2.currency cross rate options, and
options on swapsor swaptions.
are issued by a company to its employees as compensation.
Option styles
Main article:Option style Naming conventions are used to help identify properties common to many different types of options. These include:
option - an option that may only beexercisedonexpiration.
option - an option that may be exercised on any trading day on or beforeexpiration.
option - an option that may be exercised only on specified dates on or beforeexpiration.
option - any option with the general characteristic that the underlying security's price must pass a certain lever or "barrier" before it can be excercised
option - any of a broad category of options that may include complex financialstructures.
option - by definition, any option that is not exotic.
Valuation models
Main article:Valuation of optionsThe value of an option can be estimated using a variety of quantitative techniques based on theconcept of risk neutralpricing and usingstochastic calculus. The most basic model is theBlack- Scholesmodel. More sophisticated models are used to model thevolatility smile. These models

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