Features of Option Contract

Some important features of Options Contract are:

1. Highly flexible: On one hand, option contract are highly standardized and so they can be traded only in organized exchanges. Such option instruments cannot be made flexible according to the requirements of the writer as well as the user. On the other hand, there are also privately arranged options which can be traded ‘over the counter’. These instruments can be made according to the requirements of the writer and user. Thus, it combines the features of ‘futures’ as well as ‘forward’ contracts.

2. Down Payment: The option holder must pay a certain amount called ‘premium’ for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise his option, he has to forego this premium. Otherwise, this premium will be deducted from the total payoff in calculating the net payoff due to the option holder.

3. Settement: No money or commodity or share is exchanged when the contract is written. Generally this option contract terminates either at the time of exercising the option by the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required.

4. Non – Linearity: Unlike futures and forward, an option contract does not posses the property of linearity. It means that the option holder’s profit, when the value of the underlying asset moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profits and losses are not symmetrical under an option contract. This can be illustrated by means of an illustration:

Mr.X purchase a two month call option on rupee at Rs. 100=3.35 $. Suppose, the rupee appreciates within two months by 0.05 $per one hundred rupees, then the market price would be Rs. 100=3.40 $. If the option holder Mr.X exercises his option, he can purchase at the rate mentioned in the option ie., Rs. 100=3.53 $. He gets a payoff at the rate of 0.05 $ per every one hundred rupees. On the other hand, if the exchange rate moves in the opposite direction by the same amount and reaches a level of Rs. 100=3.30 $. the option holder will not exercise his option. Then, his loss will be zero. Thus, in an option contract, the gain is not equal to the loss.

5. No Obligation to Buy or Sell: In all option contracts, the option holder has a right to buy or sell an underlying asset. He can exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.