Option Agreement

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21 Aug, 2024

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Table Of Contents

What Is An Option Agreement?

The option agreement is a legally binding contract entered by two parties, one seller and the other buyer of the option, where the contract outlines that one party has the right but not the obligation to buy or sell the asset and also defines each party's responsibilities to the other which must be honored till either of the parties exits the agreement.

They agreement clarifies the type of asset, expiration date, the strike price, and the premium amount that the buyer should pay to the seller. It is used in the financial market for hedging and speculation, and its terms vary depending on the asset and parties involved. It is flexible, thus providing exposure to a larger volume of the asset to the option trader, without purchasing them.

What Is An Option Agreement?

An option agreement stands as a legally binding contract between two parties – a seller and a buyer of the option. This agreement outlines the respective obligations of both parties until either party decides to terminate the contract, ensuring that each party adheres to the stipulated terms.
In the realm of financial derivatives, two prominent categories of options emerge: call options and put options. These options allow investors to speculate on market movements and manage risk effectively.
Options contracts serve as a versatile tool, serving multiple purposes. They facilitate risk management by allowing investors to mitigate potential losses.

Option Agreement Explained

An option agreement is a contract that is legally binding and involving two parties who are agreeing to buy or sell a financial asset. The agreement has an expiration date within which or before which the option holder should exercise it or else it becomes worthless. It also has a strike price which is the price at which the agreement is to be exercised.

Option agreement in financial derivatives is an extremely versatile instrument and can be used to either speculate or hedge the position already being held. The traders or investors can protect themselves from heavy financial losses by using this strategy in case of volatile markets, be it stocks, commodities of real estate option agreement. They also use this for speculation of asset prices. Different types of agreements are used in case the investors anticipate upward price movements or downward price movements.

The exclusive option agreement becomes useful and is profitable only if the asset prices move in the direction of the expected price movement. This financial instrument has the possibility to earn high profits which also comes with losses if the strategies implemented are not proper.

So, it is advisable to do proper research and understand the concept in detail before entering into such agreements. Professional experts have the necessary skill and experience to meet the needs clients as well as abide by the applicable laws and regulations.

Types

In the financial derivatives space, there are predominately two major types of option agreement to purchase shares or any other financial asset -

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 contract collects a premium from the buyer for providing this option contract. This exclusive option agreement gives a right but not an obligation to the buyer, while for the seller, it gives an obligation that it must honor.

The above explanations give details about the put and call option agreement that option traders commonly use in the financial market.

Example

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 loss 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

Let us understand the put and call option agreement with the help of another example.

On 30^th 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 1^st November 2019, i.e., after two days, are shown in the option chain below:

Source: Marketwatch.com

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

Trade of Call Option of Strike Price $10.50: The buyer of this Option contract needs to pay $0.08 to the seller
Trade 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 1^st November 2019 and find how the buyer and seller are making the profits of each of these contracts.

Call Option

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

Call Option for Buyer and Seller

Put Option

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

Put Option for Buyer and Seller

Refer to the above given excel sheet for detail calculation.

Advantages

Just as every financial concept has its own advantages and disadvantages, so does this concept. Let us try to identify and understand them in details.

Stocks, commodities of real estate option agreement 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 underlying asset. The option trader need not actually purchase the asset to enter into an agreement. Thus, they get a large exposure to the asset volume by paying a small premium.
Option agreement provides leverage, and the entire notional value of the contract is not needed to agree.
. Thus, the leveraged position provides the facility of amplified potential gain if the underlying asset’s price moves in the anticipated direction.
Since the trader does not have to buy the asset but still gets the facility to invest by just paying the premium, the profit potential is much higher than what happens when they actually buy the asset and then earn profit in them.

Disadvantages

Some disadvantages of the concept are as follows:

These are decaying assets, and their value depreciates as they come closer to expiry.
As leverage instruments, they are extremely sensitive to the underlying asset's movement. Thus, along with the possibility of larger gain, there is also a possibility of higher loss, depending on the direction of the price movement and the type of option agreement.
The option agreement to purchase shares or sell them has to be exercised with a limited time frame. If it is not exercised within the date of expiration, it becomes worthless. This feature makes it less flexible.
The counterparty risk exists because if the option issuer fails to honor it, there may be disputes.

Frequently Asked Questions (FAQs)

1. Why use an option agreement?

Option agreements provide the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified timeframe. They are used to hedge risk, generate income, or speculate on price movements. Options offer flexibility, as they allow traders to profit in various market conditions without committing to owning the underlying asset.

2. What is a cross-option agreement?

A cross-option agreement is a legal arrangement often used in business succession planning. It involves the mutual agreement between business partners or shareholders to grant each other the option to buy (call option) or sell (put option) their respective shares in the event of a partner's death or incapacitation. This ensures a smooth transition of ownership while offering financial security to all parties involved.

3. What are the risks of an option agreement?

Option agreements come with risks, primarily related to market fluctuations and the potential loss of the premium paid for the option. The option holder could lose the entire premium if the underlying asset's price doesn't move in the anticipated direction. Additionally, if the option expires out of the money, it becomes worthless, leading to a loss of the initial investment. It's important to carefully assess the risks and rewards before entering into an option agreement.