The holder of an option has the right to buy, or sell, a specified commodity or financial instrument, at a predetermined price, on a specified date (European-type option), or throughout a specified period (American-type option). A key word in the definition is ‘right’. The buyer, or holder, of the option has no obligation to exercise the option. Therefore, an option allows a risk manager to protect the downside of a risk exposure while at the same time leaving open the opportunity to gain from any positive price movements.
Options can be distinguished on the basis of whether they provide the holder, or long party, with the right to buy (call) or sell (put) the specified underlying asset at the predetermined exercise price. The party that sells or writes the option is identified as the short party. Short calls can further be divided into covered and uncovered (naked) options. With a covered option, the writer must lodge the underlying stock, or securities to that value, with an approved trust or the clearing-house of the options exchange. In the case of naked calls, the writer must deposit an initial margin with the options exchange clearing-house and may be required to make further maintenance margin payments if adverse market price changes occur during the period of the contract.
There are exchange-traded option contracts and over-the-counter option contracts. For example, in Australia, exchange-traded options are offered through the ASX, which trades options on a number of listed companies, LEPOs and warrants, and the SFE, where options are available on futures contracts. Contracts traded on the organised exchanges are highly standardised. Banks provide an over-the-counter market where options may be written and bought based on financial instruments which the formal exchange markets do not cater for. Over-the-counter options contracts are flexible in that they enable the buyer to negotiate conditions such as amount and term.
A range of variables affects the premium paid to buy an option. The intrinsic value, being the relationship between the market price of the underlying asset and the option exercise price, is a key variable. The price of an option increases with the time to the expiration of the contract. Purely on the basis of probability, there is a greater chance that the option may be exercised if the option has a long life. Similarly, the more volatile the price of the underlying asset, the greater is the value of the option, since there is an increased probability that the price of the asset may attain a level at which it will be profitable to exercise the option. Interest rates are the other variable that affects the value of an option. Unlike the other variables, the relationship between interest rates and the value of the option differs between call and put options. In the case of a call option, there is a positive relationship, while with a put option the relationship is negative.
There is a vast range of options strategies that may be adopted by hedgers and speculators. The simplest are single-option strategies, including a long-asset and short-call strategy, and a short-asset and long-call strategy. More complex strategies involve the simultaneous purchase and/or sale of two or more option types. Strategies include a vertical bull spread, a call bull spread, a vertical bear spread, a put bear spread, a long straddle, a long strangle, a short straddle and a short strangle. Essay questions—suggested answers
The following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may be only required to briefly introduce points, explain in their own words and provide an example. On the other hand, a postgraduate student may be required to provide much greater depth of analysis and discussion.