1.1 Introduction to options
A derivative is an asset whose value is derived from that of some other asset, known as the underlying. As an example, suppose you agree a contract with a dealer that gives you the option to buy a fixed quantity of gold at a fixed price of Rs.45000 at any time in the next three months. The gold is currently worth Rs.40000 in the spot market. (A spot market is where a commodity or financial asset is bought or sold for immediate delivery.)
The option contract is a derivative and the underlying asset is gold. If the value of gold increases then so too does the value of the option, because it gives you the right (but not the obligation) to buy the metal at a fixed price. This can be seen by taking two extreme cases.
Suppose that soon after the option contract is agreed the spot value of the gold specified in the contract rises to Rs.50000. Alternatively, suppose the price collapses to Rs.35000
Spot Price Rises to Rs.50,000- If this happens you can exercise the option, buy the gold for Rs.45000 via the option and then sell the gold at a profit on the open market. The option has become rather valuable.
Spot Price Falls to Rs.35000. It is much cheaper to buy the gold in the spot market than to acquire it by exercising the option. Your option is virtually worthless. It is unlikely that it will ever be worth exercising.
As discussed in beginners module, because an option contract provides flexibility (it does not have to be exercised) an initial fee has to be paid to the dealer who writes or creates the option. This is called the option premium.
1.2 Definition of Options
The buyer of a standard or 'vanilla' financial option contract hasthe right but not the obligation:
- to buy (call option) or to sell (put option);
- an agreed amount of a specified financial asset, called the underlying;
- at a specified price, called the exercise or strike price;
- on or by a specified future date, called the expiry date.
For this right the buyer of an option pays an up-front fee called the premium to the writer of the contract. This is the most money the buyer can ever lose on the deal. On the other hand the writer of an option can face virtually unlimited losses (unless a hedge is put in place). This is because it is the buyer who decides whether to exercise (take up) the option
Exchange-traded options are mainly standardized, but settlement is guaranteed by the clearing house associated with the exchange. Over-the-counter (OTC) option contracts are agreed directly between two parties, one of which is normally a bank or securities trading house. As a result the contracts can be customized to meet the needs of specific clients. However they cannot be freely traded and there is a potential default risk - the risk that the counterparty may fail to fulfil its obligations.
1.3 Types of Options
There are two main varieties of option contract.
- Call Option- The right but not the obligation to buy the underlying asset at the strike price.
- Put Option- The right but not the obligation to sell the underlying asset at the strike price.
A so-called American-style option can be exercised on or before expiry. A European style option can only be exercised on the expiry date of the contract. In fact, these labels are historical and have nothing to do with where options are actually dealt. Most options traded on exchanges around the world are American-style. OTC options, regardless of where they are created, are often European-style. Because an American option confers additional rights, it is worth at least the same as the equivalent European contract.