Basics of an Options Contracts
- In an options contract there are two parties involved called the buyer and the writer (also called the seller).
- The writer of the option grants the buyer of the option the right, but not the obligations, to purchase from or sell to the writer something at a specified price within a specified period of time ( or at a specified date).
- The writer grants this right to the buyer in exchange for a certain sum of money, which is called the option price or optional premium.
- The price at which the underlying (that is, the asset or commodity) may be bought or sold is called the exercise price or strike price.
- The date after which the option is void is called the expiration price or maturity date.
- When the option grants the buyer the right to purchase the underlying from the writer (seller), it is referred to as a call option, or simply a call.
- When the option buyer has the right to sell the underlying to the writer, the option is called a put option, or simply, a put.
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Difference between American Options and European Options
Based upon the timing of the possible exercise of an option there are two typed of options:
- American Options: These are options that may be exercised at any time up to and including the expiration date.
- European Options: These are options that may be exercised only at the expiration date
Example of an options contract:
Suppose that A buys a call option for $3 for one unit of an Asset ABC at $100 which expires three months from now (American).
- A is the buyer of this options contract.
- Option Price paid by A to the writer is $3
- The underlying asset is one unit of Asset ABC.
- A has bought the right (but not the obligation) to purchase one unit of Asset ABC (as it is a call option) from the writer.
- The exercise price is $100.
- The expiration date is three months from now, the option can be exercised any time up to and including the expiration date (that is, it is an American option). So at any time up to and including the expiration date, A can decide to buy from the writer (seller) of this option one unit of Asset ABC, for which he will pay a price of $100.
Similarly if A buys a put option rather than a call option, then he would be able to sell Asset XYZ to the option writer for a price of $100.
- Whether the buyer exercises the option or not, the option price he paid for the option will be kept by the option writer.
- The maximum amount that an option buyer can lose is the option price.
- The maximum profit that an option writer (seller) can realize is the option price.
- The option buyer has substantial upside return potential, while the option writer has substantial downside risk.
Trading of Options: Difference between Exchange traded Options and Over the Counter Traded Options
- Options like other financial instruments, may be traded either on an organized exchange or in over-the-counter (OTC) market.
- Investment banking firms and commercials banks act as principals as well as brokers in the OTC options market.
Exchange-traded options have four advantages compared to the Over the counter traded options:
- Exchange traded options are standardized in terms of exercise price, the quantity of the underlying, and the expiration date of the contract.
- In case of Exchange traded options, the direct link between buyer and seller is limited only to initial execution of the options contract. The exchange traded options are interchangeable. The link between buyer and writer is then intermediated through the clearings house associated with the exchange where the option trades.
- The transactions costs are lower for exchange-traded options than for OTC options. The higher cost of an OTC option are because of the cost of customizing the option for institutional investors. However, the standardized exchange-traded options cannot be tailored to suit the investment objectives of institutional investors.
- Exchange traded options are more liquid than an OTC traded option.
Are there any margin Requirements in case of Exchange Traded Options?
As the buyer of an option can only get a maximum loss equal to the options price, once the option price is paid in full, there are no margin requirement for the buyer of an option. No matter how adverse the price movements of the underlying assets, the buyer of an options contract can only realise a maximum worth the options price and has tremendous upside potential. Thus no margin is needed by the buyer of the option.
The writer (seller) of an option faces tremendous downside risk in case of the adverse movement in the position of the underlying assets. The maximum profit that a writer of an option can realize is equal to the options price. The writer of the options is generally required to put up the option price received as margin.
In addition, as price changes occur that adversely affect the writer’s position, the writer is required to deposit additional margin (with some exceptions) as the position is marked to the market.
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