Options

An option is a contract giving one party the right, but not the obligation, to buy or sell a financial instrument, commodity or some other underlying asset at a given price, at or before a specified date.

An option is a contract giving one party the right, but not the obligation, to buy or sell a financial instrument, commodity or some other underlying asset at a given price, at or before a specified date. The purchaser of the option can either exercise the right or let it lapse - the choice is theirs.

Trading of standardized options contracts on a national exchange started in 1973 when the Chicago Board Options Exchange (CBOE) began listing call options. These contracts were almost immediately a great success, crowding out the previously existing over-the-counter trading in stock options.

A very simple option would be where a firm pays the owner of a piece of land a non-returnable premium (say $10,000) for an 0ption to buy the land at an agreed price (say, $1 million) because the firm is considering the development of a retail park within the next 5 years. The property developer may pay a number of option premiums to owners of land in different parts of the country. If planning permission is eventually granted on a particular plot the option to purchase may be exercised. In other words, the developer pays the price agreed at the time that the option contract was arranged, to purchase the land. Options on other plots will be allowed to lapse and will have no value. By using an option the property developer has 'kept the options open' with regard to which site to buy and develop and, indeed, whether to enter the retail park business at all.

Options can also be traded. Perhaps the option to buy could be sold to another company keener to develop a particular site than the original option purchaser. It may be sold for much more than the original $10,000 option premium, even before planning permission has been granted.

Once planning permission has been granted the site may be worth $1.5 million. If there is an option to buy at $1 million the option right has an intrinsic value of $500,000, representing a 4,900 per cent return on $10,000. From this we can see the gearing effect of options: very large sums can be gained in a short period of time for a small initial cash outlay.