Buyer’s option, seller’s option — what is it?

  An option is both a contract and a security at the same time. The securities market implies the existence of relationships between two parties — “buyer and seller.” In addition, the classification of the document also distinguishes the concepts of buyer and seller, but in this case, such a designation applies only to one party to the contract — the holder of the security. As a result, both the seller’s option and the buyer’s option are two types of the same document.

 

What is a buyer’s option?

 

  As the name suggests, when purchasing a security, its holder becomes a potential buyer of the underlying asset. The option specifies the price at which the asset can be purchased and the expiration date. The main idea of such a contract is that the fixed price (strike) remains unchanged regardless of the market situation.
  The option seller, in turn, undertakes to sell the underlying asset or compensate the amount of income that the security holder could have received from selling the asset.
  The concepts of “option buyer” and “buyer’s option” are very often confused. Despite the fact that these phrases differ from each other only in word order, they represent completely different concepts. An option buyer is a person who pays the option premium for the right to own it. A buyer’s option is a type of security that gives its holder the right to purchase the underlying asset at an agreed price. It is most often called a call option.

  Traders use such instruments to make a profit from fluctuations in the asset’s value. Essentially, a call is the same as investing in gold, currency, securities, oil, or gas, but with minimal risk and without the need to spend a large amount of money at once. The trader only needs to study the market and predict an upcoming price increase.

 

Example of using a buyer’s option

  As the underlying asset, let us take shares of a large company. Their current price is 500 rubles per share. In the near future, the company plans to sign a long-term contract with a very influential client. This step will significantly strengthen its market position, and accordingly, the share price will rise.
  After learning this, the trader decides to buy shares and later sell them at a higher price, gaining a solid profit. Since the increase may be minimal, only a few percent, to achieve real profit he would need to buy a large number of shares — at least 500 — which involves serious risks and requires having 250,000 rubles freely available. The trader decides to purchase a call option to buy 500 shares of this company at the current price (500 rubles). The option premium is 8% of the value, that is, 500 rubles × 500 shares × 8% = 20,000 rubles. The contract term is 3 weeks.
  If by the expiration date the share price has risen, the buyer has the right to demand the underlying asset at the agreed price and then sell it at the market price. If prices rise long before expiration, the trader may exercise the option early.
  Suppose the shares increased by 15%, meaning they now cost not 500 but 575 rubles. The trader exercises his right to buy the shares at 500 rubles and spends 250,000 rubles on them. These shares can be sold for 287,000 rubles (575 rubles × 500 shares). The trader’s profit will be 287,000 (current asset value) − 250,000 (strike price) − 20,000 (option premium) = 17,000 rubles.
  If the trader had not purchased the option, he would have earned 20,000 rubles more, but the risk of losing a larger amount would have increased several times. With the option, even in an unfavorable outcome, the trader would lose only 20,000 rubles spent on purchasing the option.

 

What is a seller’s option?

  In this type of security, all the rules of the game change. The option holder becomes a potential seller. He retains the right to sell the agreed asset at a fixed price. During the option’s term, the market price of the asset may fall significantly, but regardless of this, the party that issued the option is obliged to purchase the asset at the price specified in the contract.
  A seller’s option is the same as a put option. In the financial market, it mainly plays the role of a guarantor for returning funds invested in other assets. For example, a trader buys company shares, hoping for a sharp price increase in the future. However, he is not fully confident in his forecast and, in an unfavorable scenario, hopes at least to recover the amount spent on purchasing the shares. For insurance, he buys a put option, which allows him to sell the shares at the same price at which he bought them.

  Most often, however, seller’s options are used at the state level. Such contracts are concluded between different countries or between the state and part of its industries, mainly agriculture. 

  Agricultural production is characterized by the fact that invested funds pay off only after several months or even years. During this time, average prices may fall, making asset sales unprofitable. Agriculture suffers major losses, and sometimes crops are completely lost.
  For reinsurance, farms enter into option contracts with regular customers, paying them a one-time premium.
Put options are quite often confused with futures. The difference between a futures contract and an option is that the holder of a futures contract is obliged to sell the asset at a specified time. There is no premium in such an agreement. Both parties are equal: by signing the contract, they potentially forgo the profit they could earn if the asset price changed in their favor.

 

Example of using a seller’s option

  Let us take the same example as with the call option, but this time the trader has already purchased 500 shares of the company at 500 rubles each. He spent 250,000 rubles and hopes to make a profit in the future by reselling the shares at a higher price. Soon it becomes known that the company is on the verge of losing several important contracts. If these contracts do not materialize, the share price will fall sharply. The trader finds himself in a difficult situation. He will not only fail to make a profit but may also lose part of his investment. To minimize possible losses, he needs to sell the shares at least at the purchase price. To do this, he enters into an option contract and, for a fee of 20,000 rubles (8% of the share value), receives the right to sell the asset at 500 rubles per share.
  Before expiration, the shares do indeed become cheaper, quite significantly — by 25%. They now cost 375 rubles. The investor can use the option and sell them at 500 rubles, losing only 20,000 rubles (the option price).
  If he had not entered into this agreement, the losses would have amounted to 250,000 (purchase cost) − 187,500 (sale value, 500 shares × 375 rubles) = 62,500 rubles.
  Buying a put option is unprofitable if its price is higher than the possible depreciation of the asset. For example, 8% of the asset value was paid for the option, while it fell by only 5%. Thus, the buyer loses more money from purchasing the security than from selling the asset at a lower price.