The underlying is a CDS on a single reference entity or a CDS index that bundles several reference entities. The buyer pays the option premium when the trade is agreed, and no other payments are made during the life of the option.
Consider a hypothetical example in which Bank T buys a payer option on a 5-year CDS on Company U with a strike spread of 150bp. If the market spread at expiry is 200bp, Bank T can enter into a CDS at 150bp, and the difference is the gain from exercising. If the market spread is 150bp or below, Bank T does not exercise and loses the premium it paid.
An option that ceases to exist if a credit event occurs before expiry is a knock-out option. Payer options can be knock-out or non-knock-out.