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The Derivatives Options Contract
A Conditional Sales Agreement Without Obligation
May 3, 2009 © Michael N. Delahunt
An option is a price guarantee on equity. The option writer receives from the option holder
a premium, giving the holder a choice to buy or sell at some future date.
An introduction to financial derivatives
has been covered in a previous article, including definition of common terms. The four main types of
derivatives are:
forward contract, futures contract, swaps contract, and option contract.
Example to Highlight an Option Contract
Barry likes to trade stocks and options in his spare time. He believes an underlier stock ABC, currently
trading at $20 is undervalued and will increase over the next several months. Rather than buy shares and
hold them, Barry buys 6-month call options on ABC with a strike price of $20.
The options give him the right, but not the obligation, to buy ABC for $20 at anytime over the next six
months.
In 6 months, ABC is trading for $22. Barry "exercises" his options and buys ABC for $22, realizing a gross
profit of $2 per share.
Option Dynamics and Terminology
An option contract, or simply option is a price guarantee that may or may not result in a future
sale. The parties to the option are:
- The option seller (called a short party or writer)
- The option buyer (called a long party, or holder)
Upon execution, the writer receives from the holder a premium based on the option's value. In return for
the premium, the holder obtains the right but not the obligation to either:
- Buy the underlier from the writer if it's a call option. Calls gain in value
when the underlying market is going up but lose value when the market is going down
- Sell the underlier if it's a put option. Puts gain in value when the underlying market
is going down but lose value when the market is going up
The option has to be exercised (i.e. bought or sold) on, or before a specified date. Figure 1
illustrates what changes hands and when, in the case of either call or put options.
Exercise Price and Date
The price at which a holder may buy (or sell if a a put seller) is known as the strike price or exercise
price. All options specify an expiration date. The holder of an American option may exercise on or before
expiration. However, the holder of a European option may exercise only on expiration.
Option Price Paths
The price path is the course of an asset's actual price as it changes over time. When the option price is
equal to the underlier price, the option only has a time value. However, when the option price differs from
the underlier price, the option may gain in value (eg. market goes up in the case of a call). There are three
terms used:
- The option is in the money - the option pays off upon exercise
- The option is at the money - the option price is equal to the underlier price
- The option is out of the money - the option does not pay off upon exercise
Cousin to the Option - The Warrant
A financial instrument closely related to the option is the warrant. The difference is that the
writer of the contract and underlying stock issuer are the same party. For example if company XYZ writes
a call option on its own stock, then it has really written a warrant.
References:
- "All About Derivatives – The Easy Way to Get Started." Michael Durbin. McGraw-Hill,
NY. 2006
The copyright of the article The Derivatives Options Contract: A Conditional Sales Agreement Without
Obligation is owned by Michael N. Delahunt. Permission to republish in print or online must be granted by
the author in writing.
Figure 1. Options - What Changes Hands and When
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