Option

The buyer pays a premium to the writer (seller). A call gains value as the underlying rises above the strike; a put gains as it falls below. American-style options can be exercised at any time before expiry, European-style only at expiry. Options exist on equities, indices, futures, currencies, rates and commodities, and trade either listed on an exchange (standardized, centrally cleared) or OTC under an ISDA with bespoke terms.

Funds use options to hedge downside, generate income by writing covered calls, express volatility views or build asymmetric exposure. Option value depends on the underlying price, strike, time to expiry, volatility, interest rates and dividends; the sensitivities are known as the Greeks (delta, gamma, vega, theta, rho), which risk teams monitor daily.

How funds account for options. Premium paid is recorded as an asset and premium received as a liability, both carried at fair value. Listed options are usually valued at exchange settlement or mid prices (Level 1 or Level 2 if the market is thin), while OTC options use a model such as Black-Scholes with market volatility inputs. Daily changes are unrealized P&L.

Lifecycle events and pitfalls. At expiry an option is exercised, assigned or lapses. Exercise converts the option into a position in the underlying at the strike, and the premium adjusts the cost basis or proceeds. Short positions can be assigned unexpectedly on American options, especially around dividends, and the assignment must be booked the same day. Corporate actions such as special dividends or splits can adjust contract terms, which requires updating the security master. Other frequent errors are stale marks on illiquid strikes, expired contracts left open, and incorrect contract multipliers.

Example

A fund buys 20 call contracts (multiplier 100) with a USD 150 strike for a USD 4.00 premium, paying USD 8,000. At expiry the stock is USD 162; the fund exercises, buys 2,000 shares at USD 150 and records a cost basis of USD 154 per share including premium.