Options Are Powerful Tools for Risk Management
Imagine you're finally ready to book your dream vacation to Tahiti. Suddenly, Delta advertises a $400 round trip flash sale if you book in the next hour and fly in two weeks. You can't pass up this dream trip, but you don't know if your boss will approve the time off. What are you going to do? Purchase the airfare and potentially lose money if your boss says no, or do nothing and miss out on this opportunity? What if you could pay a small fee to reserve the $400 airfare? If you decide to go through with it, great. If you don't, you only lose a fraction of the cost. Well, start packing, and welcome to the world of financial options contracts.
What Is an Option?
Options are contracts that give the purchaser the right to buy or sell an underlying asset at a specified price on or before a specified date. Options contracts share much of the same framework as other derivative contracts. They are two-sided (a buyer and a seller) and used to protect against both upside and downside risk. The main difference between options and other derivatives is the contractual obligations of the buyer and the seller.
Options Contractual Obligations: Buyer vs. Seller
- The options purchaser pays a premium (fee) for the right to buy or sell the asset at the agreed price, but they have no obligation to follow through with the contract.
- The options seller is obligated to buy or sell the asset at the agreed price if the buyer decides to execute the contract, and the seller gets paid to assume that obligation.
Here’s an example: The U.S. dollar (USD) is trading at parity with the euro (EUR), so one dollar (USD) equals one euro (EUR) ($1 = 1€). You believe that the euro is going to rise in the next year. You can purchase euro right now at the cost of 1 USD to 1 EUR, or you can pay a fraction of the cost (the premium) for the right to buy euro (EUR) at the current 1:1 price sometime within the year. If the euro (EIUR) rises, you own it at 1 USD. If the euro (EUR) drops, all you’ve lost is the premium you paid.
Options are contracts that give the purchaser the right to buy or sell an underlying asset at a specified price on or before a specified date.
Know Your Options: Put OPtions and Call options
There are two types of options: put options and call options.
Put options give the purchaser the right to sell the underlying asset at a specified price no matter how low the underlying asset goes. Put options protect against falling asset prices. The contract seller collects a premium payment to assume the risk should the buyer wish to exercise his option.
Call options give the purchaser the right to buy an underlying asset at a specified price no matter how high the underlying asset rises. Call Options are essentially the opposite of puts and are used to protect against rising prices. Once again, the seller collects a premium to assume that risk from the buyer.
Like futures contracts, options always have a defined date of expiration, at which time the contract comes to the end of its life.
Cost of Options
Calculating the price of an option includes several variables:
- Price of the underlying asset
- Intrinsic value
- Time to expiration
- Volatility
Optional Conclusion
Options contracts give you an option to buy or sell, hence the name. They are nice because you don't have to follow through with the contract if your needs change. However, they do come with a price—a premium.
Takeaways
- Options are contracts that give the purchaser the right to buy or sell an underlying asset at a specified price on or before a specified date.
- The purchaser has no obligation to execute the contract, and the seller holds all the obligations.
- There are two types of options: put options give you the right to sell, and call options give you the right to buy.
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