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Options are a form of derivative financial instrument in which two parties contractually agree to transact an asset at a specified price before a future date.

An option gives its owner the right to either buy or sell an asset at the exercise price but the owner is not obligated to exercise (buy or sell) the option. When an option reaches its expiration date without being exercised, it is rendered useless with no value.

A commodity option is defined as a contract that allows a buyer the option (not the obligation) to buy or sell the commodity at a specified price and within a certain time frame. For example a trader buys the option to buy wheat at £100 per bushel. The trader would profit if the market price of wheat per bushel exceeded £100 per bushel.  

Even if the price rises significantly, subject to the contract time frame it would allow the trader to exercise the wheat at £100 per bushel. If the market price dropped below £100 per bushel, the trader would not profit from exercising the right to by the wheat at £100 per bushel and limit the loss of this transaction to the cost of buying the option.

There are two types of options, calls and puts. Call options allow the option holder to purchase an asset at a specified price before or at a particular time. Put options are opposites of calls in that they allow the holder to sell an asset at a specified price before or at a particular time. The holder of a call speculates that the value of the underlying asset will move above the exercise price (strike price) before expiry. Conversely, a holder of a put option speculates that the value of the underlying asset will move below the exercise price before expiry.

Common use
Options are used to either provide investors with the means to speculate on both positive and negative market movements of securities or help manage the risk of adverse financial market conditions and potentially offset losses.

Financial institutions such as banks provide online services that allow trading of standard option contracts (stock options, commodity options, bond options, stock index options, options on future contracts etc.) in national exchange markets (ie. London International Financial Futures and Options Exchange (LIFFE), Chicago Board Options Exchange (CBOE).

In the case of non-standard options that are tailored to satisfy specific financial needs of companies, these are called over-the-counter (OTC) options or ‘dealer options’ and are developed and underwritten by major financial institutions such as investment banks and are not traded in an open exchange. OTC options are primarily used as solutions to hedge risk of company specific risk scenarios.

Typical OTC options include interest rate option, currency option, and options on swaps (swaption). Interest rate options allow companies to set predetermined upper (cap) and lower (floor) limits on floating rates for a stated time period. The buyer of the option pays an up-front premium for the cap/floor and is guaranteed a maximum/minimum interest rate over a specified period of time. If the rate moves beyond the cap/floor rate, the writer (bank) pays the buyer a cash sum based on the difference between the actual rate and the cap rate for the amount specified in the option.

Options with upper and lower limits can also be combined to create a ‘collar’ that ensures floating interest rates are kept within those limits. Collars involve simultaneous purchase of a cap and sale of a floor by companies who are borrowing, or purchase of a floor and sale of a cap if they are protecting an investment. In this way, they are able to benefit from any favourable movements in interest rates between the 'collar rates' (cap and floor) while being protected from any adverse movements outside those limits.

Currency options are options added to FX forward contracts. At expiry of the option, users have the choice of exchanging or not exchanging currencies at the predetermined forward rate. The example below shows how different positions in currency options can be combined to hedge and/or profit against movements exchange rates.

A company that uses USD as its primary currency needs 1m GBP in three months time. The company believes that GBP is currently overvalued and is thus unwilling to buy GBP at the current spot rate of 1.6255 $/£. The company seeks a low-cost solution to cover its consequent currency exposure and to protect its budget rate of 1.6450. It believes that sterling will depreciate but is prepared to forego some participation in the benefits in return for full protection of its budget rate.
 
The company buys one sterling option from Big Bank for £1,000,000 at a strike rate of 1.6450 $/£ for a premium of 0.0125 $/£ ($12,500). Simultaneously, it sells another sterling option to Big Bank, this time for £500,000, at the same strike rate but for a premium of 0.025 $/£ ($12,500). As the premium amounts are equal, the 'contract' is zero cost.
 
At expiry, there are three possibilities:

  1. The spot rate is above 1.6450 $/£ - the company will exercise its option and purchase £1,000,000 from the bank at 1.6450 $/£. Its budget rate will be achieved although its expectation that sterling would depreciate will be proved incorrect.
  2. The spot rate is below 1.6450 $/£ - Big Bank, as purchasers of the sold option, will exercise the right to sell the company £500,000 at 1.6450 $/£. The company will then be able to buy the remaining £500,000 in the market at current rates, and enjoy some benefit from the expected sterling depreciation.
  3. The spot rate is 1.6450 $/£ - the company can either buy the £1,000,000 from Big Bank by exercising its option or allow the option to lapse and buy its sterling in the market.

Companies that regularly utilize options to manage risk tend to be large firms with large financial exposure to floating rates such as interest, FX, and commodities. The potential financial losses due to exposure amount will be the primary determinant of justifying the cost of using option derivatives to mitigate risk.

Cost
Option premium is the price of an option charged by the writer or sold on an exchange market. Option value is derived from intrinsic value (difference between current market rate and future strike price) + time value + level of price volatility. Option prices will generally be above pure option value due to reasons such as the added value the seller is providing by offering non standard structured solutions and the seller’s incentive to maximize returns. Further transaction costs and capital gains taxes may be incurred.

Prices can also vary depending on the relationship between buyer (company) and writer (bank) and average cost can be reduced by negotiating bundled services from banks. Arrangements that involve combining both call and put options allow companies to set their own rates in line with their views on rate movements and to suit their financial strategies. The premium the company pays can be offset by the premium the bank pays for the option the company sells. In some circumstances, these premiums cancel each other out and the net cost to the customer is zero.

Timeframe

The timeframe for purchasing/selling an option may vary depending on price and demand/supply dynamics. In the case of standard option transactions at listed prices, the timeframe is instantaneously online or just a phone call away. In the case of complicated derivatives that require negotiation on pricing tend to take longer and will vary depending on assessing the value of the structured solution and price negotiation between OTC counter parties.

Option expiry date vary greatly depending on the particular option. They can range from days to years. Expiry specification on hedges will be determined by the buyer’s requirement on the time period it needs to hedge.

Advantages

  • ability to hedge risk from adverse market changes on assets with floating value
  • some structured solutions provide not only the ability to hedge from adverse market movements but also reverse position to profit from such changes
  • flexibility to speculate and profit on both positive and negative changes to the value of a security.

Disadvantages

  • complicated structures require expertise in utilising options as a form of hedge or investment, creating the need to hire specialist personnel or service providers
  • not fully understanding the risks involved in investing in options or using them as hedges may result in substantial losses for a firm or individual.

Other options
The flexibility of options allows them to be structured to the needs of the customer. Other financial instruments such as swaps and futures may provide alternative means to hedging needs, but these are often used in conjunction with options to create the best possible financial solution.

Last updated: 20 Mar 2012