The Option is a type of contract that gives the holder (ie the purchaser) a right, following the payment of a price (the premium). This right allows the owner to buy or sell (depending on the type of option), at a certain date and at a price established in advance (strike price), the title is linked to the option itself, the so called underlying instrument.
If this is the first time you read this definition is easy to understand your difficulties, but don’t worry, read the example below, it will be of great help and it will clarify ideas.
An option is therefore characterized by a series of elements:
1. Underlying security
2. Exercise of a right of the buyer (to the counterparty corresponds a must)
4. The contracting parties (buyer and seller)
5. Prize and option price
6. Strike price
• There are several underlying instruments, such as equities, commodities like oil, gold, metals, merchandise, food, interest rates, indices, etc. etc..
So the options may be concluded on equities, commodities, currencies, etc…
Exercise of a right
• Depending on the exercisable right, there are two types of options: Call and Put.
1. The purchase of a call option provides to the owner the opportunity to buy the underlying stock at maturity.
2. The purchase of a put option guarantees to the holder the opportunity to sell the underlying stock at maturity.
We have highlighted the “possibility” term in order to emphasize the fact that someone who buys an option acquires the right to choose (and most importantly he isn’t obliged to do it) if to sell or to buy a title.
• Depending on when the option can be exerted (deadline) differentiate European from the American options.
1. European options allow the holder to exercise the right to a pre-fixed date (the option can be exerted only on that day and not before). For example, if the option expires on September 15, the right can’t be exercised on the day or the week before, but you have to wait for the expiry, the day 15.
2. The American options instead recognize to the owner the opportunity to exercise the right within the expiration date (ie even before that date). Thus, if in this case the option expires on September 15, this time the holder may exercise even the day following its issuance.
• We have said that option confers the right, ie a power of choice (and not an obligation), hence the name “option.” This right, that this choice to exercise the option, frees the owner to decide, at a certain time and at a specified price prefixed at the contract (the exercise price or strike price), if you buy or sell the underlying.
The holder will exercise its right if with it he will find an economic convenience, but we will see this below with an example.
The contracting parties
• Since the option is a contract, it is obvious that there is a counterpart, in fact, for anyone who buys, must necessarily be someone else who sells. The option contract is formed between a buyer and a seller.
Who buys (option holder) an option, acquires the right to choose (decide whether or not buy or sell the underlying to the expiration).
Who sells (option writer), sells exactly this possibility, and undertakes, with all the risks involved, to respect the contract if the buyer wants to exercise the option.
In short, while the seller is the issuer of the option, the buyer is the one who buys.
Prize and option price
Buy an option and ensure a right has a cost, this is called prize.
The exercise price is instead the price at which the stock will be bought or sold when and if the option is exercised.
Let’s take an explanatory example:
Suppose that the price of corn is subject to strong fluctuations due to the unpredictability of weather, and having to buy 100 tons of corn in three months, we want to avoid the risk of a sudden and excessive increase of the price, so we decide to buy 100 tons of corn at a strike price of 30€ per tonne, with an expiration date at three months and a prize (price of the option) of 3€.
Summarizing details of the operation:
• Option expires to 3 months
• Exercise price, € 30 per tonne (strike price)
• Premium, € 3 per tonne, so a total of € 300.
At this point we ask: will we exercise the option?
The choice will depend on the price of corn in three months.
Let us assume that having taken place three months, the price of corn has risen to € 35 per tonne.
Fortunately you have entered into an option, if you had not done so, today you would have purchased the corn to €35 for a tolal price of €35 x 100 = €3.500
With the option instead, you have the right to buy 100 tons of corn to €30 per tonne for a total price of €30 x 100 = €3.000. The seller in fact, by virtue of the option agreement, has the obligation to sell you 100 tons of corn to €30 per tonne.
The option will cost you € 300, but at least you managed to buy corn at a lower price with a total saving of € 200 (minus the option premium).
In this case exercise the option is clearly economically advantageous.
And if the price of corn had fallen to 10€?
Exercise the right would be economically inconvenient and see why:
Exercise the option involves the purchase of corn at a price of €30 per tonne, but now the market price of the raw material is much lower, ie €10, there’s really no reason to spend €20 in addition.
But given that is not expedient to exercise the option, what have you gained from the purchase??
It ‘s true that you have provided a cost of € 300, but at least you protected from risk. You have avoided buying the corn at a price too high, in fact, you have established a maximum purchase price (the strike price)