An option is a contract in which the buyer of an option receives the right to buy/sell an asset (commodity, security, currency, etc.) at a certain point in time at a predetermined price. The obligation to execute the option lies with its seller, who can be either the buyer (put option) or the seller (call option) of the underlying asset. You will find out more about options in this article!
- By the time of exercise, the following types of instruments are distinguished;
- European — can be exercised only on the last day of the term;
- American — can be exercised at any time before the end of the contract;
- Quasi-American — redeemed by the bearer at definite time intervals (the contract provides for one or more timeframes).
The difference between put and call options
A call option gives its buyer the right to buy the underlying asset at a fixed price at a specified time. Correspondingly, a put option gives its buyer the right to sell the asset at a given price at a given time. By buying a call option, the buyer expects the price of the underlying to rise in the future. He may then exercise his right to “buy” (e.g. gold) at the contracted price (i.e. below the market) upon expiration of the option. In the case of American-style options, the underlying asset may be bought at any time before expiration. The reverse is true for put options: the buyer waits until the price falls below the contractual price so that he may “sell” the underlying asset (the derivative seller) on it at a future.
Since the option is (usually) exercised by cash settlement, its buyer simply profits from the difference between the market price and the contract price. On the European futures market, a call option is equivalent to a long position in the underlying asset and a put option is similar to a short position. Traders Union experts assure that these assets will grow in the future
What options are used for
Typically, the option is used by buyers to hedge (reduce) risks or to make speculative profits. The sellers of this financial instrument pursue the same objective — to make a profit on the exercise of the option. To do so, they set (or calculate according to a formula) the fair premium for the option.
Experts noted that by buying an option, the buyer pays the seller pocket option fees — a cash consideration for the right to buy (sell) the underlying asset under the option contract. It incorporates the risk of adverse price movements in the underlying asset.
- The differences between an option and an outright purchase (sale) of an asset;
- limited risks (no more than the size of the option price);
- fixed settlement dates;
- no slippage (possible loss does not depend on market volatility);
- lower costs of trading on the derivatives market.
Depending on the underlying asset there are several types of options:
- commodity option;
- stock option (shares);
- currency option;
- interest rate option;
- futures contract.
Separately, we will distinguish cash commodity options, the underlying asset of which can be any physical commodity. Accordingly, the exercise of such derivative implies the actual delivery of goods, currency, real estate, etc. The underlying asset of the commodity option is the commodity itself: oil, wheat, etc.
Let us consider the principle of operation of a derivative using the example of an oil and gas company which wants to reduce the risks of a potential fall in the price of oil (which would result in a partial loss of profit). The company can purchase a put option which gives it the right to sell the commodity at the price specified in the contract within a certain period of time. By doing so, it insures itself against a fall in price below a given level. In the event of a favourable market backdrop (price increase), however, the company will not need to exercise the option right.
According to Traders Union actual delivery of goods under a commodity option (as opposed to a cash option) does not take place. If the price of oil falls below the value in the contract, the option writer pays the buyer the difference between the contract price and the market price multiplied by a given amount of oil. Options on currencies, indices and futures contracts are similar in nature to commodity options.