Financial derivative types: Options

In the volatile environment, risk of heavy fluctuations in the prices assets is very heavy. Option is yet another tool to manage such risks. As the very name implies, an option contract gives the buyer an option to buy or sell an underlying asset (stock, bond, currency, commodity etc.) at a predetermined price on or before a specified date in future. The price so predetermined is called the ‘strike price’ or ‘exercise price’.

Option is a contract that provides a right but does not impose any obligation to buy or sell a financial instrument, say a share or security. It can be exercised by the owner. Option offers the buyer, profits from favourable movement of prices say of shares or foreign exchange.

Writer: In an options contract, the seller is usually referred to as a “writer” since he is said to write the contract. It is similar to the seller who is said to be in ‘Short position’ in a forward contract. However, in a put option, the writer is in a different position. He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell.

Variants of Option: There are two variants of options i.e. European (where the holder can exercise his right on the expiry date) and American (where the holder can exercise the right, anytime between purchase date and the expiry date). It is important to note that option can be exercised by the owner (the buyer, who has the right to buy or sell), who has limited liability but possibility of realization of profits from favourable movement in the rates. Option writers on the other hand have high risk and they cover their risk through counter buying.

Types of options:

Options may fall under any one of the following main categories:

  1. Call Option
  2. Put Option
  3. Double Option

1. Call Option: A call option is one which gives the option holder the right to buy a underlying asset (commodities, foreign exchange, stocks, shares etc.) at a predetermined price called ‘exercise price’ or strike price on or before a specified date in future. In such a case, the writer of a call option is under an obligation to sell the asset at the specified price; in case he buyer exercises his option to buy. Thus, the obligation to sell arises only when the option is exercised. In short, the owner i.e. the buyer, has the right to purchase and the seller has no obligation to sell, a specified number of instruments say shares at a specified price during the time prior to expiry date.

2. Put Option: A put option is one which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. It means that the writer of a put option is under an obligation to buy the asset at the exercise price provided the option holder exercises his option to sell. In other words, owner or the buyer has the right to sell and the seller has the obligation to buy during a particular period.

3. Double Option: A double option is one which gives the option holder both the rights – either to buy or to sell an underlying asset at a predetermined price on or before a specified date in future.

Option Premium: In an option contract, the option writer agrees to buy or sell an underlying asset at a future date for an agreed price from/to the option buyer / seller at his option. This contract, like any other contract must be supported by consideration. The consideration for this contract is a sum of money called ‘premium’. The premium is nothing but the price which is required to be paid for the purchase of ‘right to buy or sell. The premium, one pays is the maximum amount to which he is exposed in the market, since in any case he can lose more than that amount. Thus, his risk is limited to that extent only. However, his gain potential is unlimited. In the case of a double option, this premium money is also double.

Options Market: Options market refers to the market where option contracts are brought and sold on the options market. The first option market namely the Chicago Board of Options Exchange was set up in 1973. Thereafter, several options markets have been established.

Benefits of Option:

Option trading is beneficial to the parties. For instance, index-based options help the investment managers to insure the portfolio against fall in prices rather than hedging each and every security individually.

Again, option writing is a source of additional income for the portfolio managers with a large portfolio of securities. Infact, large portfolio managers can guess the future movement of stock prices accurately and enter into option trading. Generally, the option writers are the most sophisticated participants in the option market and the option premiums are simply an additional source of income.

Option trading is also quite flexible and simple. For instance, option transactions are index based and so all calculations are made on the change in index value. The value at which the index points are contracted forms the basis for the calculation of profit and loss, fixing of option price etc.

In an option contract, the loss is pegged to the minimum of amount i.e., to the extent of the option premium alone. Hence, the players in the option market know that their losses can be quantified and limited to the amount of premium paid. This may also lead to high speculation. Therefore, it is very essential that option trading must be encouraged for the purpose of hedging risks and not for speculation.