Hedging 301: Financial Options – What are they?
Flexible Tools to Manage Price Risk
All businesses have risk. Most businesses like to have choices about how to best address those risks. In our first Hedging 301 post we asked this question: Could using financial options to manage risks help us achieve our desired outcome?
Before we can accurately answer that question, we need to know what a financial option is and how it operates. Today’s post will identify the fundamental characteristics of an option, which will then help us answer our key question for this series.
What are Financial Options?
Basic Building Blocks of Financial Options
The basic building blocks of a financial option are as follows:
- Underlying Commodity
- Option Type
- Strike Price
- Expiration Date
- Premium Value
1. Underlying Commodity
The first building block is more of a general description. Financial options can be created on any commodity or equity instrument. If a financial option is created on oil, we say that the underlying commodity for this option is crude oil. It is always important to make sure you have a financial option on the correct underlying commodity.
2. Option Type
Within the worlds of options, there are two basic types: call and put options. The names call and put both refer to the same ability – the ability of the owner of that option to sell or to buy the underlying commodity.
According to Option Volatility & Pricing by Sheldon Natenburg, a “call option is the right to buy or take a long [ownership] position” in the underlying commodity. A “put option is the right to sell or take a short [selling] position” in an underlying commodity. One catchy little phrase often used in the risk management world goes like this: “Call it to you or Put it away from you”.
One important thing to keep in mind with either option type – call or put – is that neither type is an obligation, only a choice to buy or sell.
3. Strike Price
But at what price would the owner of a call or put choose to buy or sell the underlying commodity? Here is where the strike price comes in. The strike price identifies at what value the owner of a call or put will transact. For example, an owner of a propane Call option at a strike price of $1.00/gallon has the right to purchase propane for the $1.00/gallon value.
4. Expiration Date
Our fourth building block tells us WHEN the owner of a call or put can make their transaction. The expiration date identifies a future time when the option must either be used or become worthless. Looking back at our propane example above, we could say that if the owner of the Call option had a future date of December 31, this means they have until that time frame to use their option.
5. Premium Value
Last, but not least, is the all-important premium value. Nothing in this world is free, and financial options are no exception. Any financial option has a cost to purchase and that is reflected in the premium value.
Conclusion
All five building blocks work together to create this final product: A propane call option with a strike price of $1.00/gallon expiring on December 31 for a premium value of $.15/gallon.
Are there more components to a financial option? Yes, but every option needs to have these five known elements. And all these elements are necessary to answer our original question – could financial options manage risks and help our business achieve the outcome we desire?
In our next post we will take these building blocks and show how options can be used effectively to manage both fixed price risk and market risk. Check out our previous series, Hedging 101 and Hedging 201, for more information about risk and other foundational hedging terms.
Keep watching over the coming weeks as we explain how financial options can be used and how they can work to provide the desired outcome for your business.
Hedging 301: Financial Options – What are they?
By JD Buss
