An option is a legal contract exchanged between a buyer and a seller. The buy-sell contract can be created for any kind of asset (stocks, commodities, currencies, indices, bonds, etc.) that has a financial value. Such a contract will have a time limit, which is also referred as the expiry period. The uniqueness of an option contract is that depending on the nature of the option, a buyer (or seller) will have the right, but not an obligation to purchase (or sell) the asset from (or to) the counter party.

The concept can be better explained through an example:

Let us assume that the two parties (A & B) are willing to enter into a precious metal (gold) transaction. The parties sign up an option contract such that the party A (buyer) has the right, but not an obligation to purchase the yellow metal from the party B at a pre-determined price (for example $1,300/tr.oz). The contract will also have a stipulated expiry date and time. Once again, let us believe that the mutually accepted expiry time of the intended transaction is 3PM on August 31st, 2016. For the party B to hold the gold bars till the end of expiry, the party A pays $1500. In this case, the party A is the option holder, while the party B is referred as the option writer.

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On the evening of August 31st, the contract can be closed in two manners, as explained below:

  1. The closing bid for gold at the London Metal exchange is $1500/tr.oz – the option holder (party A) would be more than willing to take the delivery of gold bars as per the contract terms (quantity, price at $1300/tr. oz, etc.). The party B will have no legal right to walk away from the contract.
  2. The closing bid for the gold at the London Metal exchange is $1200/tr.oz – the option holder (party A) will be less interested in taking delivery as per the contract terms (quantity, price at $1300/tr. oz, etc.). In such a circumstance, the party A can allow the contract to expire. The option writer (party B) will have no legal right to force the party A to take delivery. However, the party B can keep the initial amount of $1,500 paid by the party A at the time of execution of the contract.

In the above mentioned example, the buyer had the right, but not an obligation to purchase the gold bars. Such an option is called as ‘Call option’.

On the contrary, if the seller had the right, but not an obligation to sell the gold bars, then such an option is called as ‘Put option’. In this case the seller will be the option holder and the buyer would be the option writer.

Subjectmoney

The value of the option contract changes with the change in the price of the underlying asset, albeit with some differences, which we look in later topics. Since the option derives its value from the price of an underlying asset, it is considered as a derivative product in the financial world.
To sum up, the main differences between a call and put option are as follows:

Call option

Party A

  1. Predicts a rise in the price of an asset.
  2. Purchases call option (turns into an option holder).
  3. Pays premium to party B for holding the asset.
  4. Receives right, but has no obligation to purchase the asset from the counter-party.
  5. If prediction goes true, then party A can purchase the asset at the contracted price. Alternatively, the contract can be resold to another willing buyer at the prevailing rate in the market. There is no limit to the profit.
  6. If the forecast fails, the party A can refuse to purchase the asset. However, the premium paid to part B cannot be claimed back. Thus, net loss will be equal to the premium paid.

Party B

  1. Expects a decline in the price of the asset.
  2. Sells call option (turns into an option writer).
  3. Receives premium for the risk taken.
  4. Cannot shy away from selling the asset as per the contract terms, if the option holder demands at the time of expiry.
  5. If the price of the asset declines as anticipated, then the option writer receives profit equivalent to the premium paid by the party A (option holder). The maximum profit is limited to the premium paid.
  6. If the prediction goes wrong, then the asset should be delivered to the option holder or the contract should be repurchased at the prevailing price from the market. The loss can be theoretically unlimited for an option writer.

Put option

Party A

  1. Predicts a fall in the price of an asset.
  2. Purchases put option (turns into an option holder).
  3. Pays premium to party B for waiting to purchase the asset.
  4. Receives right, but has no obligation to sell the asset to the counter-party.
  5. If prediction goes true, then party A can sell the asset at the contracted price. Alternatively, the contract can be resold to another willing buyer at the prevailing rate in the market. There is no limit to the profit.
  6. If the forecast fails, the party A can refuse to sell the asset. However, the premium paid to part B cannot be claimed back. Thus, net loss will be equal to the premium paid.

Party B

  1. Expects a rise in the price of the asset.
  2. Sells put option (turns into an option writer).
  3. Receives premium for the risk taken.
  4. Cannot shy away from buying the asset as per the contract terms, if the option holder demands at the time of expiry.
  5. If the price of the asset declines as anticipated, then the option writer receives profit equivalent to the premium paid by the party A (option holder). The maximum profit is limited to the premium paid.
  6. If the prediction goes wrong, then the asset should be bought from the option holder or the contract should be repurchased at the prevailing price from the market. The loss can be theoretically unlimited for an option writer.

There are mainly two different kinds of option contracts. They are:

  1. Exchange traded options: These are standard call and put options traded on an exchange. The exchange traded options are generally referred to as vanilla options. In the case of call options, the premium increases with the rise in the price of the underlying asset. Likewise, in the case of put options, the premium increases with the fall in the price of the underlying asset.
  2. Binary or digital options: It is more commonly referred as ‘all or nothing’ options. If the trader’s prediction goes right, then the option holder will receive a return of up to 90% in normal circumstances. The trader will lose the entire investment (barring few contracts with ‘return on loss’ features), if the prediction goes wrong.