Options Contract

An options contract is a type of contract under which a potential buyer or seller of an underlying asset receives the right, rather than an obligation, to purchase or sell the underlying asset at a price calculated in advance according to a specified formula, at the moment defined in the contract; the number of payments and their frequency can also be specified.

The seller is obliged to sell or buy the asset from the buyer of the options contract in accordance with the terms. As a rule, the initial purchase of an options contract is paid; if the options contract is exercised, the buyer may need to pay multiple components of the transaction. Sometimes, the exercise of an options contract is free of charge, for example, bonus stock options for company employees based on the price difference.

An options contract is one of the financial instruments. It is customary to distinguish put options, call options, and double options.

An options contract and a futures contract are similar financial instruments in many ways, but with some important differences.

Stock and Over-The-Counter Options Contracts

Stock option contracts are standardized contracts for which the exchange sets the contract specifications. The amount of the premium on option contracts is negotiated by the participants. The option price is published by the exchange, and this value represents the average price for the option on that day. Option contracts with different strike prices or expiration dates are considered separate contracts. Margin requirements may apply, typically to sellers of the option contract.

Over-the-counter option contracts are concluded on arbitrary terms agreed upon by the participants at the time of the transaction. Today, the main buyers of over-the-counter option contracts are large financial institutions that need to hedge their investment portfolios and open positions. They may require non-standard expiration dates. The main sellers are large investment companies.

FX Options Contract

An FX options contract is an option in the Forex market, where the buyer has the right to exchange one currency for another on a specified date at a pre-agreed rate.

These options are primarily used by importers or exporters to hedge against exchange rate fluctuations between the contract currency and the domestic currency.

Types of Option Contracts

There are several types of option contracts, based on the right to buy or sell the underlying asset:

• Call option — a purchase option; the buyer can buy the underlying asset at a fixed price.
• Put option — a sell option; the buyer can sell the underlying asset at a fixed price.

Accordingly, there are four types of option transactions:

• Sale of a put option.
• Purchase of a put option.
• Sale of a call option.
• Purchase of a call option.

Two types of option contracts are most common: American and European.

• American options can be exercised any day before expiration.
• European options can be exercised only on the designated expiration date.

The Premium of an Options Contract

The option premium is the amount of money the buyer pays to the seller when concluding an options contract. This payment represents the right to conclude the transaction in the future. Its value is set by the balance of supply and demand in the market.

Pricing Models of an Options Contract

All pricing models are based on the idea of a fair market, where the “fair” premium corresponds to the contract’s value. A key factor influencing the premium is the volatility of the underlying asset: the greater the volatility, the higher the uncertainty about the future price, and the higher the premium demanded by the seller. Another important factor is the time remaining until expiration: the longer the time, the higher the premium.

The price is also affected by interest rates and dividends from the underlying asset.

Non-Standard or Exotic Option Contracts

Since the over-the-counter market of option contracts is characterized by flexible approaches, additional variables began to be included in the hedging of options in response to requests from buyers, and they began to affect the amount of the premium, its decrease or increase. Some successful inventions began to be used en masse, so exotic options appeared. It happened around the end of the 80s of the XX century. Exotic options include, for example, a barrier option contract, an Asian option, a binary option contract, etc.

Automatic Execution of an Options Contract

In most countries, the procedure for exercising an options contract is generally not legislatively regulated, so some exchanges have automated cash-settled execution. This reduces the risk of late exercise notification.