Financial Options

By: EconomyWatch   Date: 23 November 2010

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Financial options are those derivatives contracts in which the underlying assets are financial instruments such as stocks, bonds or an interest rate. The options on financial instruments provide a buyer with the right to either buy or sell the underlying financial instruments at a specified price on a specified future date. Although the buyer gets the rights to buy or sell the underlying options, there is no obligation to exercise this option. However, the seller of the contract is under an obligation to buy or sell the underlying instruments if the option is exercised.

Two types of financial options exist, namely call options and put options. Under a call option, the buyer of the contract gets the right to buy the financial instrument at the specified price at a future date, whereas a put option gives the buyer the right to sell the same at the specified price at the specified future date. The price that is paid by the buyer to the seller for exercising this level of flexibility is called the premium. The prescribed future price is called the strike price.

How is Financial Options Traded?

Financial options are either traded in an organized stock exchange or over-the-counter. The exchange traded options are known as standardized options. The options exchange is responsible for this standardization. This is done by specifying the quantity of the underlying financial instrument, its price and the future date of the expiration. The details of these specifications may vary from exchange to exchange. However, the broad outlines are similar.


Benefits of Financial Options

Financial options are used either to hedge against risks by buying contracts that will pay out if something with negative financial consequences happens, or because it allows traders to magnify gains while limiting downside risks.

Risks of Financial Options

Financial options involve the risk of losing some or all of the contract price, if the market moves against the trend expected, and counterparty risks, such as broker insolvency or contractors who do not fulfil their contractual obligations.


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