An embedded option is an option which forms a part of another security and is not traded as a separate identity. Embedded options can take various forms.
Warrants which are hybrid securities include options along with a debt offered at a lower rate of return compared to normal debt (without options) that would have been issued at a higher rate of return. These options form a part of the instrument i.e. warrants in this case and hence are embedded with it. Once the warrants are sold, these options might be detachable to be traded separately.
Embedded options may also refer to the option available to the bondholder or he issuer to perform an action. For example the issuer may have the embedded option to call a bond. Such bonds are called callable bonds.