Options
Leveraged derivative instruments as their own prices are derived from the prices of various underlying assets including
Gilts
Corporate bonds 8
Indices such as Standard & Poor's 500
Crypto-currencies
So called because the holders have options as to what can and cannot be done
Tend to be for the more sophisticated investor and it may be very difficult to trade OTC options
In order to trade OTC options it will usually be necessary to engage the services of specialist options brokers, which are few and far between
Two categories
Traditional options are OTC bespoke financial products without exchanges with their individual terms and conditions such as their strike price and expiry date being negotiated by the writer and the holder
Exchange traded options are traded on exchanges such as Euronext.liffe
Purchased by a party referred to as the holder from another party referred to as the writer
They give a holder the right (without any obligation) either to buy or sell standard quantities of an underlying asset on or before a specified future date
The price at which the underlying asset may be bought or sold is known as the strike price and will be agreed when an option is purchased
The amount a holder will pay to either a writer or a broker for an option is referred to as the option premium
The option premium will never be returned to the holder
There are two types of option
Call options: provide the holder with the right (without obligation) to buy an underlying asset
Put options: provide the holder with the right (without obligation) to sell an underlying asset
At the point where the holder pays the option premium to the writer (or a broker in the secondary market) there is possession of an option without any obligation
A contractual obligation is created whereby in the event of exercise of the option by the holder, the writer must deliver in the case of call options and must buy in the case of put options
There are also obligations placed on the holder, including to pay the option premium as agreed and to pay the strike price if the option is exercised or provide the underlying asset if a put option is exercised
When the option premium is purchased no rights in relation to any underlying assets are acquired unless the option is actually exercised
Options terminology
Options writer
Not only the creator of the option but also the first seller
When the option has been created and is in the possession of the holder it may be traded usually through a broker just like equities
A purchaser may buy or sell either call or put options in the secondary market without having to deal with the original writer
The writer must either provide the underlying asset to the current holder (call option) or buy it from the holder (put option) in the event of exercise
Holder
The party in current possession of the option either brought form the option writer or through a broker
Standard quantity
Options are traded only in whole numbers
Underlying
Is the asset upon which the option is based
Expiry date
The last day on which an option may be exercised
There are three styles of exercise
American: may be exercised at any time up to and including the expiry date
European: May be exercised only on the expiry date
Bermudan: Which can be exercised at a number of pre-specified times before expiry
Strike price
The price at which the option holder may purchase from or sell to the underlying asset from/to the writer, should the holder decide to exercise the option
This is the price at which the writer must provide the asset (or buy it from) the holder
Option premium
The price that the holder must pay to the writer or broker for the option that is for the right to buy or sell an underlying asset
Made up of two elements: intrinsic value and time value
Upfront payments paid to the writers or brokers that will never be returned to the holder and the holder must still pay the strike price in full
Call options
Give the holders the right (without obligation) to buy a standardised quantity of an underlying asset at the strike price
The writer has a contractual obligation t sell the underlying asset to the holder in the event that the option is exercised by the holder
A purchaser of a call option believes that a particular share price will rise
The writer believes that the holder will not be able to exercise the option profitably, this would mean that the option premium can be kept as profit by the writer
The maximum loss to the holder is the option premium, the maximum profit for the writer is also the option premium
Option holders will only exercise an option if is profitable to do so
Put options
Give the holder the right without obligation to sell a standardised quantity of an underlying asset to the writer at the strike price
The writer has a contractual obligation to buy the underlying asset from the holder if the holder exercises the option