Option Agreement Definition Example Top 2 Types Of Option Agreement

Option Agreement Definition

Types of Option Agreement

In the financial derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more space, there are predominately two major types of options –

Call Option: It gives the buyer of the option contract the right to buy the underlying at a certain price decided while buying the contract, on or before the expiry of the contract. During the sale, the seller of the Call option contract collects a premium from the buyer for providing this option contract. This contract gives a right but not an obligation to the buyer, while for the seller, it gives an obligation that it must honor.Put Option: It gives the buyer of the option contract the right to sell the underlying at a certain price decided while buying the contract, on or before the expiry of the contract. During the time of sale, the seller of the Put option contractPut Option ContractPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more collects a premium from the buyer for providing this option contract. This contract gives a right but not an obligation to the buyer, while for the seller, it gives an obligation that it must honor.

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Example of Option Agreement

The following are the example of the Option Agreement.

Example #1

The stock of XYZ Inc. is trading at $100 at the start of the month. Person A wants to buy a Call option (and enter into an Option Agreement) today so he can buy the stock at $100 at the end of the month. He wants to do this because he believes that at the end of the month, the stock price will go much above $100, and yet owing to the Option agreement he has entered, he will still be able to get it for $100. He stands with this quote in the exchange, hoping some seller would sell this contract to him.

After some time, another person B’s attention is caught by this quote, and he evaluates the chances of XYZ Inc. still trading at $100 or more at the end of the current month. After careful consideration, he feels there is no question of this stock trading above $100 at the end of the month.

B wants to make some easy money and indicates to A that he is willing to sell the Call option for a premium of $5. A agrees and pays $5, and B sells him the call option as he desires. Neither of them had any stock of XYZ Inc. with them when they entered into this option agreement.

Solution

Case-1 – The stock is trading at $115 at the end of the month. A, using the option agreement that he entered with B, buys a stock at $100 from B and immediately sells it in the market at $115, making a profit of $15. He had to pay $5 as an option premium, so his profit net is $15-$5=$10. On the other hand, B had to buy the stock at $115 from the market and sell it at $100 to A, making a loss of $15 in the process. But he had collected $5 from A when entering the contract, so his net lossNet LossNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet.read more is $15-$5=$10. It can be observed that the loss of B is the profit of A.

Case-2 – The stock is trading at $95 at the end of the month. A doesn’t want to use the option agreement as it will require him to buy the stock at $100 while he can easily buy it at a lesser price from the market. He can do this as he is an option buyer and has the right and not an obligation to exercise his right. As the option is not exercised, it expires worthless, and the premium of $5 that B had collected, he gets to keep to himself.

Case-3 – The stock is trading at $105 at the end of the month. A, using the option contract agreement, buys the stock at $100 from B and sells it in the market immediately after that, thereby making a profit of $5. But he also had to pay an upfront premium of $5. So-net, he makes no profit, no loss. Similarly, B incurs the loss of $5 by first buying the stock at $105 and then selling it to A at $100, but he had collected $5 as a premium upfront, and thus he makes no loss or gain.

Example #2 – Practical Application-Based

On 30th Nov 2019, General Electric Co. was trading at $10.04. The snapshot of the quote is shown below:

The prices of the different options (both Call & Puts) of General Electric Co. expiring on 1st November 2019, i.e., after two days, are shown in the option chainThe Option ChainAn option chain is a detailed representation of all available option contracts for an asset. It provides a quick picture of all available put and calls options of the asset with their pricing, volume, open interest details to analyze and take appropriate and immediate actions.read more below:

Source: Marketwatch.com

Two examples are selected from this option and the same has been highlighted above:

Trade of Call Option of Strike PriceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more $10.50: The buyer of this Option contract needs to pay $0.08 to the sellerTrade of Put Option of Strike Price $10.00: The buyer of this Option contract needs to pay $0.11 to the seller

The attached excel reader can enter the value of the stock they expect the stock to be at the end of the trading session on 1st November 2019 and find how the buyer and seller are making the profits of each of these contracts.

Call Option

Strike Price: $10.50Option Premium: $0.08Stock Price at Expiry: $12

Call Option for Buyer and Seller

Put Option

Strike Price: $10.00Option Premium: $0.11Stock Price at Expiry: $9

Put Option for Buyer and Seller

Refer to the above given excel sheet for detail calculation.

Advantages of Option Agreement

Option agreements are used as risk management tools. Going long on options contracts can be used to hedge the movement of underlying.It can be used to speculate without needing to have exposure to underlyingOption agreement provides leverage, and the entire notional valueNotional ValueNotional Value is the face value of the underlying financial instrument. In the case of derivatives, it is generally the value of the underlying assets and is derived by multiplying the total number of units in the contract by the market spot price of the said units.read more of the contract is not needed to agree.

Disadvantages of Option Agreement

These are decaying assets, and their value depreciates as they come closer to expiry.As leverage instruments, they are extremely sensitive to the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more‘s movement.

Conclusion

Option agreement in financial derivatives is an extremely versatile instrument and can be used to either speculate or hedge the position already being held.