- Published on
Investment - Option Contracts
What if the farmer does not want to lock in the price because the farmer feels the price of wheat is going to increase? But the farmer does want to make sure that at least a certain amount is obtained for the wheat. Similarly, the cereal producer anticipates that the price of wheat is likely to decline and wants to make sure that no more than a specific amount is paid. Option markets may give the solution for both parties.
Options provide one party (the buyer) to the contract the ability to demand an action from the other party (the seller) in the future. In an option contract, the buyer of the option has the right, but not the responsibility, to buy or sell the underlying. Options are dubbed unilateral contracts since only one party to the transaction (the seller) has a future promise that, if broken, marks a breach of contract. Unilateral transactions expose solely the buyer to the risk that the seller will not fulfil the contractual commitment.
The buyer of the contract will exercise the right or option if conditions are favourable or if certain conditions are met. For this reason, options are sometimes known as contingent claims — that is, claims are dependent on future conditions. If the buyer agrees to use (exercise) the option, the seller is bound to meet the option buyer’s claim. If the buyer decides not to exercise the option, it expires without any action by the seller.
Options may trade in the over-the-counter market, but they trade largely on exchanges. Here, we focus on options traded on exchanges. Options on the over-the-counter market are identical, except that they are customized. An option contract specifies the underlying, the size, the price to trade the underlying in the future (called the exercise price or striking price), and the expiration date. Option contracts in the United States normally expire in March, June, September, or December, but options are available for other months as well.
A buyer selects whether to exercise an option depending on the underlying’s price compared with the exercise price. A buyer will exercise the option only when doing so is favorable compared with trading on the market, which puts the seller at a disadvantage. Because of the unilateral future obligation (only the seller has a responsibility), options have positive value for the buyer at the inception of the contract. The option buyer pays this value, or option premium, to the option seller at the time of the initial contract.
The premium paid by the option buyer compensates the option seller for the risk incurred; the option seller is the only party with a future obligation. The highest gain to the option seller is the premium. The option seller hopes the option will not be exercised.
Call Options and Put Options
There are two fundamental sorts of options:
Call Option
An investor who buys a call option has the right (but not the responsibility) to buy or call the underlying from the option seller at the exercise price until the option expires.
Put Option
An investor who buys a put option has the right (but not the responsibility) to sell or put the underlying to the option seller at the exercise price until expiration.
The cereal producer may acquire a call option to ensure the right, but not the responsibility, to buy wheat at the exercise price. The farmer may buy a put option to protect the right, but not the responsibility, to sell wheat at the exercise price. Note that the grain producer and farmer enter into various option contracts to control their risks.
Example: Illustration of a Call Option
Consider a call option in which the underlying is 1,000 shares of fictitious Company A trading on the London Stock Exchange (LSE). The call option’s exercise price is GBP6.00 per share, which indicates that the call option buyer can buy 1,000 shares of Company A at GBP6.00 per share until expiration, regardless of Company A’s share price in the market.
Note that the buyer will exercise this option only if Company A’s price on the LSE is more than GBP6.00 per share. If Company A’s share price at expiration is GBP7.00 per share, the buyer executes the option, pays GBP6,000, and receives 1,000 shares of Company A. The call option buyer can then sell those shares in the market for a profit of GBP1,000 (ignoring transaction fees, such as the premium initially paid for the call option and trading costs). The seller of the call option is compelled to sell the shares at GBP6.00 per share to the call option buyer, even if the market price is GP7.00 per share, incurring a loss of GBP1,000 (ignoring the premium received for the call option).
If Company A’s share price is less than GBP6.00 per share, the call option buyer has no motivation to execute the option; it would not make sense to voluntarily pay more than the market price. In this instance, the buyer will let the option expire. Because an option buyer is not obligated to exercise an option, an option’s value cannot be negative.
The example above indicates that, ignoring the premium paid, an option buyer’s pay-off is never negative. Option buyers pay premiums to option sellers to compensate option sellers for their risk. But if an option seller underestimates the risk associated with the option, the premiums paid may be substantially less than the losses they experience on exercise.
Buying call options protects the investor by establishing a maximum price the option buyer will have to pay to buy the underlying; the maximum price is the exercise price. Similarly, buying put options protects the investor by establishing a minimum price the option buyer will get to sell the underlying; the minimum price is the exercise price.
An option that yields a positive payoff if it is exercised is said to be ‘in the money’. When the underlying price is at the exercise price, the option is said to be ‘at the money’. When the underlying price has not reached the exercise price (lower for a call, higher for a put), the option is said to be ‘out of the money’. The definition of whether the option is in-, at-, or out-of-the-money is referred to as the option’s ‘moneyness’.
Example: Option Moneyness and Pay-offs
The entire value of an option consists of two components: an intrinsic value and a temporal value. The intrinsic value of an option is the difference between the strike price and the underlying asset price. The time value is the value associated with the amount of time left until an option expires and is derived by subtracting the intrinsic value from the overall value of the option.
For a call option, a buyer will benefit by exercising the option when the underlying asset price is more than the strike price (the intrinsic value is positive) and will not exercise when the spot price is below the strike price (intrinsic value is zero).
A buyer of a put option will exercise at a market spot price lower than the strike price (option is in-the-money, the intrinsic value is positive). When the underlying asset price is higher than the strike price, the buyer will not exercise (option is out-of-the-money, intrinsic value is zero).
Factors that Affect Option Premiums
Option premiums are meant to pay option sellers for their risk. The option premium indicates the greatest profit that the option seller can make. If an option seller underestimates the risk connected with the option, the premiums may be substantially less than the losses sustained if the option is exercised.
The lower the exercise price for a call option relative to the current spot price, the higher the premium because the likelihood that it will be exercised is greater. The higher the exercise price for a put option relative to the current spot price, the larger the premium because the likelihood that it will be exercised is greater.
The longer the time to expiration of an option, the higher the option premium since the possibility is greater that the underlying will move in favour of the option buyer and that it will be exercised. Similarly, the greater the volatility of the underlying, the higher the option premium since the likelihood is greater that the underlying will shift in favour of the option buyer and that it will be exercised.
In essence, an option’s premium depends on the current spot price of the underlying, exercise price, time to expiration, and volatility of the underlying.
The following table demonstrates the impact of an increase in each element on an option's premium for a call option and a put option.
Warrants
A warrant is an equity-like product that authorizes the holder to buy a pre-specified amount of common stock of the issuing business at a pre-specified per-share price (called the exercise price or strike price) prior to a pre-specified expiration date. Warrants often have expiration dates several years in the future. A corporation may issue warrants to investors to obtain funds or to employees as a form of compensation.
The holders of warrants may choose to exercise the rights prior to the expiration date. A warrant holder will exercise the right only when the price of a common share surpasses the exercise price. Otherwise, it would be cheaper to acquire the shares in the market. When a warrant holder exercises the right, the corporation issues the pre-specified number of new shares and sells them to the warrant holder at the exercise price.
When warrants are utilized as employee remuneration, they are referred to as employee stock options. The goal of employing warrants as pay is to connect the interests of the employees with those of the owners.
What if the farmer does not want to lock in the price because the farmer feels the price of wheat is going to increase? But the farmer does want to make sure that at least a certain amount is obtained for the wheat. Similarly, the cereal producer anticipates that the price of wheat is likely to decline and wants to make sure that no more than a specific amount is paid. Option markets may give the solution for both parties.
Options provide one party (the buyer) to the contract the ability to demand an action from the other party (the seller) in the future. In an option contract, the buyer of the option has the right, but not the responsibility, to buy or sell the underlying. Options are dubbed unilateral contracts since only one party to the transaction (the seller) has a future promise that, if broken, marks a breach of contract. Unilateral transactions expose solely the buyer to the risk that the seller will not fulfil the contractual commitment.
The buyer of the contract will exercise the right or option if conditions are favourable or if certain conditions are met. For this reason, options are sometimes known as contingent claims — that is, claims are dependent on future conditions. If the buyer agrees to use (exercise) the option, the seller is bound to meet the option buyer’s claim. If the buyer decides not to exercise the option, it expires without any action by the seller.
Options may trade in the over-the-counter market, but they trade largely on exchanges. Here, we focus on options traded on exchanges. Options on the over-the-counter market are identical, except that they are customized. An option contract specifies the underlying, the size, the price to trade the underlying in the future (called the exercise price or striking price), and the expiration date. Option contracts in the United States normally expire in March, June, September, or December, but options are available for other months as well.
A buyer selects whether to exercise an option depending on the underlying’s price compared with the exercise price. A buyer will exercise the option only when doing so is favorable compared with trading on the market, which puts the seller at a disadvantage. Because of the unilateral future obligation (only the seller has a responsibility), options have positive value for the buyer at the inception of the contract. The option buyer pays this value, or option premium, to the option seller at the time of the initial contract.
The premium paid by the option buyer compensates the option seller for the risk incurred; the option seller is the only party with a future obligation. The highest gain to the option seller is the premium. The option seller hopes the option will not be exercised.
Call Options and Put Options
There are two fundamental sorts of options:
Call Option
An investor who buys a call option has the right (but not the responsibility) to buy or call the underlying from the option seller at the exercise price until the option expires.
Put Option
An investor who buys a put option has the right (but not the responsibility) to sell or put the underlying to the option seller at the exercise price until expiration.
The cereal producer may acquire a call option to ensure the right, but not the responsibility, to buy wheat at the exercise price. The farmer may buy a put option to protect the right, but not the responsibility, to sell wheat at the exercise price. Note that the grain producer and farmer enter into various option contracts to control their risks.
Example: Illustration of a Call Option
Consider a call option in which the underlying is 1,000 shares of fictitious Company A trading on the London Stock Exchange (LSE). The call option’s exercise price is GBP6.00 per share, which indicates that the call option buyer can buy 1,000 shares of Company A at GBP6.00 per share until expiration, regardless of Company A’s share price in the market.
Note that the buyer will exercise this option only if Company A’s price on the LSE is more than GBP6.00 per share. If Company A’s share price at expiration is GBP7.00 per share, the buyer executes the option, pays GBP6,000, and receives 1,000 shares of Company A. The call option buyer can then sell those shares in the market for a profit of GBP1,000 (ignoring transaction fees, such as the premium initially paid for the call option and trading costs). The seller of the call option is compelled to sell the shares at GBP6.00 per share to the call option buyer, even if the market price is GP7.00 per share, incurring a loss of GBP1,000 (ignoring the premium received for the call option).
If Company A’s share price is less than GBP6.00 per share, the call option buyer has no motivation to execute the option; it would not make sense to voluntarily pay more than the market price. In this instance, the buyer will let the option expire. Because an option buyer is not obligated to exercise an option, an option’s value cannot be negative.
The example above indicates that, ignoring the premium paid, an option buyer’s pay-off is never negative. Option buyers pay premiums to option sellers to compensate option sellers for their risk. But if an option seller underestimates the risk associated with the option, the premiums paid may be substantially less than the losses they experience on exercise.
Buying call options protects the investor by establishing a maximum price the option buyer will have to pay to buy the underlying; the maximum price is the exercise price. Similarly, buying put options protects the investor by establishing a minimum price the option buyer will get to sell the underlying; the minimum price is the exercise price.
An option that yields a positive payoff if it is exercised is said to be ‘in the money’. When the underlying price is at the exercise price, the option is said to be ‘at the money’. When the underlying price has not reached the exercise price (lower for a call, higher for a put), the option is said to be ‘out of the money’. The definition of whether the option is in-, at-, or out-of-the-money is referred to as the option’s ‘moneyness’.
Example: Option Moneyness and Pay-offs
The entire value of an option consists of two components: an intrinsic value and a temporal value. The intrinsic value of an option is the difference between the strike price and the underlying asset price. The time value is the value associated with the amount of time left until an option expires and is derived by subtracting the intrinsic value from the overall value of the option.
For a call option, a buyer will benefit by exercising the option when the underlying asset price is more than the strike price (the intrinsic value is positive) and will not exercise when the spot price is below the strike price (intrinsic value is zero).
A buyer of a put option will exercise at a market spot price lower than the strike price (option is in-the-money, the intrinsic value is positive). When the underlying asset price is higher than the strike price, the buyer will not exercise (option is out-of-the-money, intrinsic value is zero).
Factors that Affect Option Premiums
Option premiums are meant to pay option sellers for their risk. The option premium indicates the greatest profit that the option seller can make. If an option seller underestimates the risk connected with the option, the premiums may be substantially less than the losses sustained if the option is exercised.
The lower the exercise price for a call option relative to the current spot price, the higher the premium because the likelihood that it will be exercised is greater. The higher the exercise price for a put option relative to the current spot price, the larger the premium because the likelihood that it will be exercised is greater.
The longer the time to expiration of an option, the higher the option premium since the possibility is greater that the underlying will move in favour of the option buyer and that it will be exercised. Similarly, the greater the volatility of the underlying, the higher the option premium since the likelihood is greater that the underlying will shift in favour of the option buyer and that it will be exercised.
In essence, an option’s premium depends on the current spot price of the underlying, exercise price, time to expiration, and volatility of the underlying.
The following table demonstrates the impact of an increase in each element on an option's premium for a call option and a put option.
Warrants
A warrant is an equity-like product that authorizes the holder to buy a pre-specified amount of common stock of the issuing business at a pre-specified per-share price (called the exercise price or strike price) prior to a pre-specified expiration date. Warrants often have expiration dates several years in the future. A corporation may issue warrants to investors to obtain funds or to employees as a form of compensation.
The holders of warrants may choose to exercise the rights prior to the expiration date. A warrant holder will exercise the right only when the price of a common share surpasses the exercise price. Otherwise, it would be cheaper to acquire the shares in the market. When a warrant holder exercises the right, the corporation issues the pre-specified number of new shares and sells them to the warrant holder at the exercise price.
When warrants are utilized as employee remuneration, they are referred to as employee stock options. The goal of employing warrants as pay is to connect the interests of the employees with those of the owners.
0 Comments