Issue #6: Options
Hello friends, welcome to Issue 6 of Finance “Yoga” with Emmanuel Inyada. Last week we looked at the term #Derivative. We would continue with the discussion this week and in subsequent weeks as we will be looking at the different types of derivatives. Our term for this week is “Options” which is a type of derivative. Let’s get right into it.
Simply, an option is a derivative contract which gives the buyer (the holder of the the option) the right but not the obligation to buy or sell the underlying asset or investment at a specified strike price prior to or on a specified date. An options contract offers the buyer the opportunity to buy or sell the underlying asset where its value is obtained from. It is an agreement between two parties to facilitate a potential transaction on the underlying asset at preset price, prior to the expiration date.
The stated price on the option contract is referred to as strike price, while the prevailing market price is known as the spot price.
The options contract is a right not an obligation. This means that the holder of the contract is not required to buy or sell the asset if they choose not to. This is what differentiates it from a futures contract.
An options contract usually represents 100 shares of the underlying asset or security and the buyer or holder of the option pays a premium fee for each contract. The underlying asset could be securities, commodities, real estate etc.
History and Evolution
The use of options dates back to Ancient Greece though it wasn’t called options then. The earliest recorded example of the use of options dates back to the 4th Century B.C. in a book written by Aristotle titled “Politics”. Here, he wrote about Thales of Miletus and how he profited from an olive harvest.
The tale is that Thales who had vast knowledge of many subjects including astronomy and mathematics, by application of his knowledge, was able to predict that there would be a vast olive harvest that year. He, thus, sought to profit from his prediction. Recognising that there would be a large demand for olive presses, he sought to have control of the market. Not having enough money to own all the presses, he paid the owners to secure the right to use the presses during harvest. When harvest time came, the harvest was huge. Thales was right in his prediction. He then resold his rights to the olive presses to those who needed them and made a sizeable profit.
By this act, Thales effectively created the first call option with olive presses as the underlying asset. He had paid for the right but not the obligation to use the olive presses at a fixed price and was then able to exercise his option for a profit. This is the basic principle on how call options work today.
Options have also been used in different forms with a wide range of underlying assets throughout history. There are also several notable events which includes the Tulip Bulb Mania of Holland in the 17th Century, the different bans placed on options trading, Russell Sage’s creation of the Call and Put Options which can be traded over the counter in the United States in the 19th Century, and the creation of the Chicago Board of Options Exchange (CBOE) in 1973.
Today, there are millions of transactions carried out in the options market throughout the world. Options are usually bought or sold through online or retail brokers.
Types of Options
There are two types of options:
Call Option: A call option allows the holder to buy the asset at a stated strike price within a specified timeframe, which is usually the expiry date called the expiry. A call option is bought if the trader expects the underlying asset to rise within a certain timeframe.
Put Option: A put option allows the holder to sell the asset at a stated strike price within a specified timeframe. A put option is bought if the trader expects the price of the underlying asset to fall within a certain timeframe.
Furthermore, we also have American options which can be exercised anytime before the expiration date, and European options which can only be exercised on the expiration date or exercise date. Exercising here means the right to buy or sell the underlying security.
Essential Features of an Options Contract
In sum, these are the essential features of an options contract:
- It is a derivative contract.
- Like all other derivatives, its existence is hinged on the existence of an underlying asset.
- It gives the holder of the contract the right not the obligation to buy or sell the underlying asset.
- It must have a specific expiration date upon which the exercise of the option by the holder is based.
Usage in a Sentence
So now we can say:
“The options market gives the advantage of hedging against certain risks in the market.”
” Emmanuel bought the options at $50 per contract.”
“The Chicago Board of Options Exchange is the largest options exchange in the world.”
“Concerned stakeholders called for better regulation of the options market.”
I hope you have learned something new about Finance this week.
That will be all for Issue 6 of Finance “Yoga”. We will continue the discussion on Derivatives next week as will be looking at another type of derivative. Leave your comments below and do not forget to share.
Remember, finance is not that hard.
Have a super blessed week!
About the Author
Emmanuel Inyada is a Lagos based legal practitioner with growing experience in dispute resolution, energy and finance law. He is the Co-founder of Law Axis 360°. You can reach him at firstname.lastname@example.org