A financial option is a financial derivative that involves a contract to buy or sell an underlying asset, which grants the buyer the right to buy or sell the underlying asset agreed in a previously agreed future, depending on whether it is a call option or option selling.
The main characteristics of an option are indicated by its own name. The term ‘option’ refers precisely to the fact that the buyer of said financial derivative has the right (has the option) to execute the provisions of the contract. At the same time, the seller of an option is obliged to sell if the buyer exercises his right after the term.
Relationship between financial option and financial future
Financial options are a type of financial derivative very similar to financial futures, but while Futures and Forwards consist of derivatives that represent an obligation, options are financial contracts that carry a right (not an obligation) for the buyer.
This right gives the possibility to buy or sell certain goods or titles (the underlying asset) at a specified price, during a stipulated period of time. For this right, the buyer of the same will pay a price called the option premium. For its part, the seller of the option is obliged to sell the underlying asset at the exercise price on the expiration date or before, in exchange for the collection of a premium.
As it is a right, it supposes that if the buyer of the option has not guessed correctly in the price trend, he is not obliged to buy/sell the underlying, he simply will not exercise his right as it is anti-economic, resulting in the loss only in the premium (or price) paid for that right.
Example of financial option
Although they seem complex instruments, the truth is that we can see options outside the financial markets, suppose that:
A person is very interested in acquiring a certain house in cash valued at € 300,000, but at the moment he does not have the total, and he has immobilized the part that he lacks for up to 6 months. The buyer can reach an agreement with the owner that reserves the option to buy the house for € 300,000 within 6 months in exchange for a counter-benefit (price of the purchase option or premium).
In the previous example, we see how the buyer has the right (not the obligation) to buy at maturity. The seller for his part has the obligation to sell if the buyer wants to exercise his right to buy. Options can be made on a speculative basis, without the existence of a commercial transaction, but they are usually used for reasons of coverage of commercial or financial operations.
Depending on whether the option can be exercised before or only on the expiration date, a distinction is made between:
- European options: They can only be exercised on the expiration date. Before that date, they can be bought or sold if there is a market where they are traded.
- American options: They can be exercised at any time between the day of purchase and the expiration day, both inclusive, and regardless of the market in which they are traded.
To learn more about financial options, read Financial Options – Types and Examples.