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In our last article we looked at all the important details related to futures contracts. In this article we will focus on options contracts, the second major type of derivatives.

An option is an agreement between two counterparties in which the buyer has the right (not the obligation) to buy or sell an underlying asset, at a certain maturity and at an agreed price called a strike. For this right, the buyer of the option pays the seller a premium which is the price of the option. We shouldn’t make a confusion between the premium of the option and the strike.

The buyer of the option can’t lose more than the premium, and the seller can’t win more than the premium. The buyer can win an unlimited amount and the seller can lose an unlimited amount. Only the buyer of the option can exercise this option. If he exercises it, the seller is forced to sell or to buy the underlying asset at the strike.

From the point of view of the right offered by the option, there are two types:

• PUT option – gives the right to sell
• CALL option – gives the right to buy

From the point of view of the moment when the option can be exercised we have:

• European options – which can only be exercised at maturity
• American options – which can be exercised anytime until maturity

From the point of view of the delivery method we have:

• Options with physical delivery
• Options with cash delivery

The significance of these notions is similar with what those for futures contracts. The buyer is also called LONG and the seller SHORT.

Example:

1) CALL 100.000 EUR/USD, strike=1.1040, maturity 30th of September, premium: 0.85%

The buyer of this option has the right to buy 100.000 euro against dollars at an exchange rate of 1.1040. If the option is European, the buyer can exercise it only on the 30th of September 2016. If the option is American, the buyer can exercise it at any time until the 30th of September 2016. For this option the buyer has paid a premium of

0.85% * 100.000 = 850 euro

In case the buyer exercises this option, the seller has an obligation to sell 100.000 euro against dollars at an exchange of 1.1040.

2) PUT 1000 AAPL, strike=100$, maturity 16th of September 2016, bonus 1.15$

The buyer of this option has the right to sell 1000 shares of Apple stocks at a price of 100$ per stock. For this right he paid 1.15$ per stock. If the buyer exercises this option, the seller has the obligation to buy 1000 Apple stocks at a price of 100$ per share.

The options presented above fall into the “plain vanilla” category. Generally “plain vanilla” refers to the simplest form of financial instruments. If further details are added with regard to how the options work they will fall under the category of “exotic”.

Barrier, Digitals, Asian, Bermudan and Compound are examples of Exotic Options.

As underlying assets we can have:

• The exchange rate
  
• A tradeable commodity such as: oil, gold, coffee, wheat etc.
• Stock index
• A bond
• A bond index
• Stocks
• Other derivative financial instruments

The options can be traded on an exchange or on OTC. For example, we can have options on the exchange rate which can be traded on the stock exchange and through banks. What must be noted is that the options traded through the exchange are standardized contracts and the details can be found in the contract specifications.

The option sellers must always deposit a guarantee. In some special cases the buyers must also deposit a guarantee. Just as with the futures contracts we trade options to speculate or hedge.

There are financial instruments which have a more complicated way of working. For example there are derivatives based on interest rates or interest rate indexes, like Euribor or Robor:

• Forward/Forward
• Forward Rate Agreement
• Forward Rate Guarantee
• Interest Rate Swap
• Cross Currency Interest Rate Swap
• Options

A special category of derivatives, with a complex way of working, are credit derivatives. In this category we have:

• Credit Default Swap (CDS)
• CDS options
• Total Return Swap
• Credit-Liked Notes
• Mortgage Backed Securities
• Collateralized Debt Obligations
• Collateralized Loan Obligations

Because of their complexity, these instruments are dedicated to professional investors.

You can find out much more about instruments and financial markets by registering for our Finance and Banking for IT specialists courses. 

Valentin Cioraneanu
Investment Banking Specialist