BASIC CHARACTERISTICS OF OPTIONS

The fixed price at which the option holder can buy or sell the underlying is called the exercise price, strike price, striking price, or strike. The use of this right to buy or sell the underlying is referred to as exercise or exercising the option. Like all derivative contracts, an option has an expiration date, giving rise to the notion of an option’s time to expiration. When the expiration date arrives, an option that is not exercised simply expires. What happens at exercise depends on the whether the option is a call or a put. If the buyer is exercising a call, she pays the exercise price and receives either the underlying or an equivalent cash settlement. On the opposite side of the transaction is the seller, who receives the exercise price from the buyer and delivers the underlying, or alternatively, pays an equivalent cash settlement. If the buyer is exercising a put, she delivers the stock and receives the exercise price or an equivalent cash settlement. The seller, therefore, receives the underlying and must pay the exercise price or the equivalent cash settlement. As noted in the above paragraph, cash settlement is possible. In that case, the option holder exercising a call receives the difference between the market value of the underlying and the exercise price from the seller in cash. If the option holder exercises a put, she receives the difference between the exercise price and the market value of the underlying in cash.There are two primary exercise styles associated with options. One type of option has European-style exercise, which means that the option can be exercised only on its expiration day. In some cases, expiration could occur during that day; in others, exercise can occur only when the option has expired. In either case, such an option is called a European option. The other style of exercise is American-style exercise. Such an option can be exercised on any day through the expiration day and is generally called an American option.
Option contracts specify a designated number of units of the underlying. For exchange-listed, standardized options, the exchange establishes each term, with the exception of the price. The price is negotiated by the two parties. For an over-the-counter option, the two parties decide each of the terms through negotiation.
In an over-the-counter option–one created off of an exchange by any two parties who agree to trade-the buyer is subject to the possibility of the writer defaulting. When the buyer exercises, the writer must either deliver the stock or cash if a call, or pay for the stock or pay cash if a put. If the writer cannot do so for financial reasons, the option holder faces a credit loss. Because the option holder paid the price up front and is not required to do anything else, the seller does not face any credit risk. Thus, although credit risk is bilateral in forward contracts-the long assumes the risk of the short defaulting, and the short assumes the risk of the long defaulting-the credit risk in an option is unilateral. Only the buyer faces credit risk because only the seller can default. As we discuss later, in exchange- listed options, the clearinghouse guarantees payment to the buyer.