Option Agreement Definition
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 exit the agreement.
Types of Option Agreement
In financial derivatives space, there are predominately two major types of option –
- Call Option: It gives the buyer of the option contract, right to buy 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 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 which it must honor.
- Put Option: It gives the buyer of the option contract, 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 contract gives a right but not an obligation to the buyer while for the seller it gives an obligation which it must honor.
Example of Option Agreement
The following are the example of the Option Agreement.
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 that he can buy the stock at $100 at the end of the month. He wants to do this because he is of the view that at the end of the month the price of the stock will go much above $100 and yet owing to the Option agreement, he has entered into he will be able to still get it $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 present month. After careful consideration, he feels that there is no question of this stock trading above $100 at the end of the month.
B wants to make some easy money and gives an indication 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 desired. Neither of them had any stock of XYZ Inc. with them when they entered into this option agreement.
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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 as $115 and making a profit of $15. He had to upfront pay $5 as option premium so net of both his Profit is $15-$5=$10. B, on the other hand, 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 into 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 that will need him to buy the stock at $100 while he can buy it easily at a lesser price from the market. He can do this as he is an option buyer and he 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 it 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 had to also 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 premium upfront and thus he makes no loss or gain either.
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 of different options (both Call & Puts) of General Electric Co. expiring on 1st November 2019 i.e. after 2 days are shown in the option chain below:
Two examples are selected from this option and the same has been highlighted above:
- Trade of Call Option of Strike Price $10.50: Buyer of this Option contract needs to pay $0.08 to the seller
- Trade of Put Option of Strike Price $10.00: Buyer of this Option contract needs to pay $0.11 to the seller
In the attached excel reader can enter the value of the stock he/she expects the stock to be at the end of the trading session on 1st November 2019 and find how the profits are being made by the buyer and seller of each of these contracts.
- Strike Price: $10.50
- Option Premium: $0.08
- Stock Price at Expiry: $12
Call Option for Buyer and Seller
- 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 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.
- Can be used to speculate without having the need to have exposure to underlying
- Option agreement provides leverage and the entire notional value of the contract is not needed to enter into the agreement.
Disadvantages of Option Agreement
- These are decaying assets and their value depreciates as it comes closer to its expiry.
- Being leverages instrument they are extremely sensitive to the movement of the underlying asset.
Option agreement in the field of financial derivatives is extremely versatile instruments and can be used to either speculate or hedge the position that is already being held.
This has been a guide to the Option Agreement and its definition. Here we discuss types of option agreement along with practical examples, advantages, and disadvantages. You can learn more from the following articles –