What are options?

An option is a contract between two parties whereby the owner acquires the right to receive (a Call Option) or deliver (a Put Option) an asset at a pre-agreed price (the Strike Price) or the cash equivalent of the difference between the Strike Price and value of the asset (the Determination Price), upon a pre-agreed date (the Expiry Date) in return for a cash payment (the Option Premium).

Hence, the maximum loss for the holder is the Option Premium and the maximum gain may be unlimited. Whereas, the economics are the reverse for the seller (known as the writer) whose return is limited to the Option Premium and the downside risk could be significant. So why do people write options? To earn the Option Premium.

Over-The-Counter options

Options my be traded between two parties (over-the-counter options) or on an exchange (listed options).

Payoffs from options                                       

The payoff on the Expiry Date for a Call Option is the maximum of the excess of the Determination Price excess the Strike Price on the Expiry Date or zero. Hence, holders of Call Options should expect the asset price to rise.

The payoff on the Expiry Date for a Put Option is the Maximum of the excess of the Strike Price over the Determination Price on the Expiry Date or zero. Hence, holders of Put Options should expect the asset price to fall.

There are a wide range of options beyond simple call and put options. The more sophisticated options are known as exotic options.

In a number of countries, options are taxable as capital gains because all of the premium can be lost, although the treatment will vary from country to country. Investors should seek their own advice in respect of taxation etc.

In addition to the credit risk of the option seller and the market risk that the options does not pay any return, there are a number of other risks associated with options (see Risks of Structured Investing).

 

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