A financial option is a financial derivative that involves a contract to buy or sell an underlying asset, such as a stock, currency pair, commodity or other, which grants the buyer the right to buy or sell the agreed underlying asset at a future date previously agreed, depending on whether it is a call option or a put option.

The main characteristics of an option are indicated by its own name. The term ‘option’ refers precisely to the fact that the buyer of this financial derivative has the right (has the option) to execute the provisions of the contract. At the same time, the seller of an option is required to buy or sell (depending on the type of option) if the buyer exercises his right once the contract expires.

In short, options are a premium paid for the right to secure a future price of another asset (underlying asset), either to buy or sell it.

In this article, we will explain the parts involved, the types of options and we will see an example. It is important to remember that there are two parts to option contracts:

  • Option buyer (Long position in the option): It is the party that has the right to exercise the buy or sell of the underlying asset (stocks, bonds, commodities, indices, currencies, etc).
  • Option seller (Short position in the option): It is the party that is obliged to buy or sell the underlying asset at the agreed price if the buyer exercises his right.

Two types of contracts with two parties each can cause four different situations in which the trader can find himself. In the following image, you can see the graphs that reflect the profit or loss against the variation in the price of the Underlying Asset (eg shares) in the market.

Financial options diagram

X is the exercise price

We can also see the summary of the four situations in the table below.

Call OptionSeller (Writer)Buyer
Right or ObligationObligation to sell the underlying assetRight to buy the underlying asset
Investor ExpectationsBearishBullish
Investor EarningsOption PremiumUnlimited
Potential lossesUnlimitedOption premium

 

Put OptionSeller (Writer)Buyer
Right or ObligationObligation to buy the underlying assetRight to sell the underlying asset
Investor ExpectationsBullishBearish
Investor EarningsUnlimitedOption premium
Potential lossesOption premiumUnlimited

Types of options depending on their expiration

Depending on whether the option can be exercised before or only on the expiration date, a distinction is made between:

  • European options: They can only be exercised on the expiration date. Before that date, they can be bought or sold if there is a market where they are traded.
  • American options: They can be exercised at any time between the day of purchase and the expiration day, both inclusive, and regardless of the market in which they are traded.

Example of an option trade

After reading the above explanation, the concept of options may not be clear to beginners, and this is because they are complex financial instruments. So let’s see an example:

Let’s suppose that Apple’s shares are currently at $100, and we know that next month the company is going to take out a new iPhone and we believe that this will increase the value of its shares. We then decided to buy Call options with a strike price of $100 and a maturity of three months, which in the market cost $5 each. This means that within three months we will be able to exercise the option, and then the seller will deliver the shares to us for $100. Three situations can occur:

  • The shares are below the strike price ($100), and so we will not exercise the option and lose the premium since we are not going to buy at $100 something that costs less.
  • Between $100 and $105, we will reduce the losses until they reach zero at $105. In this price zone, the option is exercised since we will always lose less than the $5 of the premium. If we buy the shares at $100 when the current price is at $102.5 and taking into account the premium paid for the option, then we lose only part of the premium (-$2.5).
  • From $105 we always exercise the option and we will also start to have benefits. If we buy at $100 plus the $5 premium something that costs $110, we have a benefit of $5.

Relationship between options and futures

Financial options are a type of financial derivative very similar to financial futures, but while Futures and Forwards consist of derivatives that represent an obligation, options are financial contracts that carry a right (not an obligation) for the buyer.

This right gives the possibility to buy or sell certain goods or titles (the underlying asset) at a specified price, during a stipulated period of time. For this right, the buyer of the same will pay a price called the option premium. For its part, the seller of the option has the obligation to buy/ sell the underlying asset at the exercise price on the expiration date or before, in exchange for the collection of a premium.

As it is a right, it supposes that if the buyer of the option has not been right regarding the price movement, he is not obliged to buy/sell the underlying, he simply will not exercise his right as it is anti-economic, resulting in the loss only in the premium (or price) paid for that right.

Where can we trade options?

Financial options are usually traded on centralized exchanges like CME Group in the form of standardized contracts, based on a wide variety of assets, including commodity, currency, and equity futures. There is also a large market for OTC options.

Only brokers and intermediaries who have access to these markets allow to trade options. Forex and CFD brokers usually do not offer these financial instruments, as they do not have access to the options markets. However, the following brokers offer OTC currency option contracts:

However, the options traded in these brokers do not involve the buy/sell and delivery of the currencies traded in these contracts directly, as in the case of options traded on the options exchange. Only the gain/loss produced by the exercise of the options is credited/debited in the trader’s account. As we said before, these are non-standard Vanilla OTC currency options. However, on these platforms, the trader can implement all the strategies that can be used with traditional options.