What are financial options?

  Financial options are one of the many types of securities. They are used for trading, that is, for making profit directly from the trading process itself. Options are also one of the most reliable ways to insure investments.

 

General concepts in financial options

 

  Options are securities and at the same time a contract in which one of the parties receives the right to buy or sell an underlying asset at a fixed price in exchange for a premium.
  The option premium is the amount that the seller receives from the buyer. The premium balances the risk and potential income of both parties. Under the contract, the buyer has only rights, but no obligations: he may either exercise his option or not do so. The seller, on the contrary, bears only obligations, and in return requests a premium.

  The option premium is also called its price. The level of the premium depends on many factors: the behavior of the asset on the market, analysts’ forecasts, the level of the market price, and the strike price of the asset. Usually, the price is from 6 to 8% of the total investment amount — this is a normal indicator provided that the level of risk for both parties is the same. If the seller’s chance of financial loss increases, the premium also increases accordingly.
  In any outcome of the transaction, the premium remains with the seller. Exceptions may include special offers, such as currency options with deposit coverage. Banks make such offers to attract additional clients. To further increase the attractiveness of their services, they promise to refund the option premium in case it is exercised. If the security remains unused, this amount stays with the bank.
  The strike is the price agreed upon in the option. It remains unchanged throughout the entire execution period regardless of the state of the financial market. The profit of both parties to the agreement depends on the relationship between the strike and the market price.
  Usually, the strike price is set according to the market price, that is, an average indicator over a certain period and the value valid at the moment the transaction is concluded are taken. In some options, it is possible to set the strike price regardless of the market situation. This is reasonable only if there are additional terms of the agreement that will in one way or another affect the risk and profitability of the contract.
  The expiration period is the duration of the option. It can be short-term (from an hour to a week) or long-term (from a week to several months). The longer the expiration period, the higher the premium percentage.
  Execution is the very fact of exercising the option. In the options market, this term is more commonly called expiration. It can be timely or early. Early expiration is available only when purchasing an American option; European contracts can be exercised only at the agreed moment.
  The underlying asset is the main object of the contract. Depending on what exactly serves in this role, financial options can be divided into several types.

 

Types of financial options by asset type

 There are exchange-traded and over-the-counter options. Over-the-counter options, in turn, can be divided into commodity and currency.
  Exchange-traded options are most often used to buy or sell shares, but other securities can also be used as the underlying asset.

  Commodity options appeared earlier than others. Any tangible good, from gold to food products, can act as the underlying asset.
  Currency options are used in the Forex market. Most often, they are used to hedge currency investments, that is, to insure one transaction with the help of another.

Call and put options

  A more global classification of options depends on what specific right will be granted to the buyer of the security.
  A call option allows the purchase of an asset at an agreed price. Most often, it is used to make a profit from price fluctuations.
  A put option is the opposite of a call. Its holder acts as the seller of the asset, and the option seller is obliged to purchase this asset at the agreed price.

 

Deliverable and cash-settled options

  The first option transactions always ended with the delivery of the asset, which was their main purpose.
  Deliverable options have recently been used only in commodity relations; in currency or stock exchanges, cash-settled types of transactions have become more widespread.
  Cash-settled options do not even imply the acquisition of the asset. The option seller simply compensates the buyer’s profit. This is much easier and more convenient for both parties to the agreement.