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Derivatives: Options

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Options serve a similar purpose to forwards and futures, in the sense that they could also, for instance, entitle the purchaser to purchase an asset at a specified price (the ‘strike price’) on a predetermined future date. However, options can be more beneficial to the holder in the sense that, unlike futures or forwards, the contract for an option does not obligate the holder of the option to actually take up the option when the relevant date arrives. Instead, the contract gives them the option, at their own discretion, to go ahead with the transaction. As such, options are typically more expensive than futures or forwards. There are two main types of options: call options and put options.

  • Call Options: these give the purchaser the option (but confer no obligation upon them) to buy an underlying asset in the future at a predetermined price.
  • Put Options: these give the purchaser the option  (but confer no obligation upon them) to sell an underlying asset in the future at a predetermined price.

If the market price happens to decrease by the time the predetermined date at which the option may be taken up arrives, the holder of the option can simply refrain from exercising their option and instead purchase the desired asset directly from the market at its current (potentially cheaper) price. This additional benefit favours the purchaser of the option and as such, the seller of the option under such circumstances would usually require the purchaser to pay a premium.

For example, if you purchase a call option that entitles you to buy 1000 of Company A’s shares for £10 each in 1 month’s time, but in a month, the market price is actually £8 per share, you can choose not to exercise (take up) the option and instead purchase the shares at the cheaper price. However, if Company A’s shares happen to be trading for £12 each in a month’s time, you can exercise the option and take advantage of the £2 saving per share. In this example, if the market price of the shares is above £10 while the option is still active, then the option is described as being ‘in the money’ as it entitles the (call) option holder to purchase the shares at a price that is lower than the market price. Conversely, if the option was a put option, it would be described as ‘in the money’ if it entitled the seller to sell at a price that is higher than the market price.

It can be important to know some of the key factors that may influence the price of an option, however a full understanding of the factors is not typically expected of you at the interview stage. Some of these factors are included in the below table.

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By Jake Schogger - City Career Series