Definition of an OPTION contract

Transcription

1 Options Contracts - Definition Definition of an OPTION contract An OPTION contract is an agreement in which a seller (writer) conveys to a buyer (holder) of a contract the right, but not the obligation, to buy or sell a specific quantity of something at a specified price on or before a specified date The option writer has the obligation to fulfill his side of the contract if the option holder decides to exercise the option

2 Options Contracts - Definition Options are derivative contracts derived from the underlying global commodity price A financial agreement between two parties that gives the buyer the right to buy a futures contract within a specified time at a specific price level Options have an upfront cost (like an insurance policy) Options are a paper contract that gives you the option to buy or sell at a later date, without the obligation to do so Options are transferable and standardised contracts that specify: Price Quantity Delivery date Settlement date

3 Options Contracts - Terminology CALL Option Gives the buyer (option holder) the right to BUY the underlying asset by certain date at a certain price Gives protection against RISING prices PUT Option Gives the buyer (option holder) the right to SELL the underlying asset by certain date at a certain price Gives protection against FALLING prices

4 Options Contracts - Terminology STRIKE PRICE The price at which the underlying asset is bought or sold upon exercise of the option PREMIUM The market price or the amount paid to purchase the option EXPIRATION DATE The last day the option may be exercised EXERCISING The act of cashing in the option to realize the financial benefit (i.e. its worth)

5 Options Contracts Terminology variety of options AMERICAN OPTION options which can be exercised during the whole duration of the contract, i.e. at any time on or before the specified maturity date EUROPEAN OPTION options which can be exercised only at the end of the contract or at the maturity date i.e. on a specified date ASIAN OPTION option whose payoff depends on the average price of the underlying asset over a certain period of time as opposed to at maturity. Also known as an average option

6 Options Contracts - Terminology OPTIONS can be BOUGHT or SOLD CALL BUY a CALL Option Get the right to BUY an underlying asset SELL a CALL Option Give the right to BUY an underlying asset PUT BUY a PUT Option Get the right to SELL an underlying asset SELL a PUT Option Give the right to SELL an underlying asset

7 Options Contracts Put Options This example illustrates how a put option provides a trader with a price floor, protecting him from a falling coffee price (if it falls below the floor level chosen) Experience of price volatility without a price floor Experience of price volatility with a price floor Price Floor Protected Less Costs of Protection = Price Received Planting Harvest Sale Market Price Planting Harvest Sale

8 Options Contracts Put Options Example when Prices Fall Physical Position Put Option Utilization APRIL: Trader purchases 10,000 lbs coffee at basis 140 cents/lb APRIL: Trader purchases a put option for 10, cents lb Cost: $0.04 cent/lb September international coffee price at 130 cents / lb SEPTEMBER: Sells coffee at 130 cents / lb (10 cents/lb loss) SEPTEMBER: Exercises options at 140 cents / lb (10 cents/lb gain) (minus 4 cents/lb cost of options) Position per lb = 10 cent / lb loss on physical coffee plus gain of 10 cents / lb on options minus 4 cent/lb option premium

9 Options Contracts Put Options Example when Prices Rise Physical Position Put Option Utilization APRIL: Trader purchases 10,000 lbs coffee at basis 140 cents/lb APRIL: Trader purchases a put option for 10, cents lb Cost: $0.04 cent/lb September international coffee price at 150 cents / lb SEPTEMBER: Sells coffee at 150 cents / lb (10 cents/lb gain) SEPTEMBER: Options expire no return as they are out of the money (loss of 4 cent/lb option cost) Position per lb = 10 cent/lb gain on physical coffee, no gain on options contract minus 4 cent/lb option premium

10 Options Contracts Call Options Call Options provide a trader with protection against prices rising Experience of price volatility without a price ceiling Experience of price volatility with a price ceiling Global Market Price $1.65 Global Price Paid = Global Market Price $1.65 Strike Price $1.55 Global Price Paid =Global Market Price + Cost of the Protection $1.58/lb Planting Harvest Sale Planting Harvest Sale

11 Options Contracts Call Option Example when Prices Rise Physical Position APRIL: Call Option Utilization APRIL: Trader agrees to deliver 10,000 lbs coffee at basis 140 cents/lb in September Trader purchases a call option for 10, cents lb Cost: $0.04 cent/lb September international coffee price at 150 cents / lb SEPTEMBER: SEPTEMBER: Purchases 10,000 lbs of coffee to meet contracted delivery obligations at 150 cents/lb Exercises options and realizes 10 cents / lb (minus 4 cent/lb cost of option) Position per lb = 10 cent / lb loss on physical coffee plus 10 cents / lb gain on options minus 4 cent/lb option premium

12 Options Contracts Call Option Example when Prices Fall Physical Position APRIL: Trader agrees to deliver 10,000 lbs coffee at basis 140 cents/lb in September Call Option Utilization APRIL: Trader purchases a call option for 10, cents lb Cost: $0.04 cent/lb September international coffee price at 130 cents / lb SEPTEMBER: Purchases 10,000 lbs of coffee to meet contracted delivery obligations at 130 cents/lb (gain of 10 cents / lb) SEPTEMBER: Options expire no return as they are out of the money (loss of 4 cent/lb cost of option) Position per lb = 10 cent / lb gain on physical coffee with no gain on options minus 4 cent/lb option premium

13 Options Contracts Options Payouts An option has value (pays out) or is in the money when the market price at the time of exercising the option is: For a put option, below the strike price For a call option, above the strike price IN THE MONEY An in the money option has a strike price that is more advantageous than the current market price of the underlying asset OUT OF THE MONEY In an out of the money option the price of the underlying is more advantageous than the strike price of the option AT THE MONEY If there is no-profit, no-loss by exercising option at that moment in time INTRINSIC VALUE Refers to the amount by which an option is IN THE MONEY

14 Options Contracts The Cost of Using Options The Cost of Using Options Using options has a cost Represents the market price of a particular option at a particular time Must be paid in cash in advance of purchasing the option contract Options typically cost between 3-8% of the underlying contract value The cost of an option will depend on the price that you wish to protect; the length of time that you wish to have the protection for; and the current level of volatility in the coffee market

15 Options Contracts Options Premiums Options Premiums are determined by: 1. Underlying market price of coffee 2. Exercise or strike price 3. Term to option maturity 4. Marketplace volatility 5. Short term rates Mathematical calculation on the possibility that at some time in the future the option will be exercisable

16 Options Contracts Advantages and Limitations of Using Options BENEFITS Allows strategic sales decisions Provides price protection & peace of mind Allows greater access to credits (less risky financial situation) Costs involved are limited and known upfront RISKS & CONSTRAINTS BASIS Risk is not covered Requires significant managerial commitment ie, learning and ongoing administration Doesn t solve all commodity risks

17 Options Contracts Summary An option contract is an agreement in which a seller conveys to a buyer of a contract the right, but not the obligation, to buy or sell a specific quantity of something at a specified price on or before a specified date Options have an upfront cost the premium Call options give the buyer the right to BUY the underlying asset by certain date at a certain price Put options give the buyer the right to SELL the underlying asset by a certain date at a certain price Options contracts are not perfect as they have an upfront cost and are subject to basis risk