An option on a CDS tranche. It gives the holder the right, but without the obligation, to buy or sell an underlying tranche at a specific exercise date (or over the term of the option ending by that exercise date) at a specific coupon level. A CDS tranche is a portion/ slice of a security or debt issue, that has its own risk-return profile. The separate tranches can be packaged and sold to individual investors or groups of investors to account for each investor’s desired level of risk (credit protection requirements).

Upon exercising the option, the option buyer can settle for tranche loss arising prior to the option expiration date (for a European-style option: European tranche option). The option’s premium depends on the remaining tranche notional amount.

This option gives the buyer the right, but not the obligation, to receive or sell protection on a portfolio of names/ reference entities/ assets/ issuers for a predetermined premium (upfront default insurance cost). The strike price is written on the market value of the underlying credit product (such as a CDS) at the option’s expiration date. Therefore, the tranche option does not knock out after a portfolio undergoes a default event.

A tranche option is a type of credit portfolio derivatives.