The Essence of Optionality

An option contract can be written for just about any financial or business transaction.

The buyer of the option is seeking the right to do something for a defined period of time before the option contract expires. For example, a business that leases commercial space to sell furniture may want to have the option to expand into the space adjacent to their current store with the same terms as their current lease.

This option allows the tenant to lock in terms and plan for the future without being required to fulfill the terms. We say that they have the right, but not the obligation, to secure the additional space for a specific price. There is normally a time limit for the option to be used. The writer of this option is the landlord. The landlord is obligated to honor those terms if the tenant chooses to exercise the option to expand.

Because the landlord is giving up the opportunity to lease the space for a higher price, there is usually a cost for this option. The terms of this option can vary dramatically based on all other factors of the lease as well as other market conditions.

This type of option is non-standardized. That means the terms and language of the option are flexible and up for negotiation. It’s an option for a very specific situation.

A standardized option, the type we are discussing in this course, is an option contract which involves a security or commodity that is traded on an exchange. Stocks, currencies, futures, commodities, etc. are examples of standardized financial products which can have standardized options contracts.