Investors interested in structured products should have a general familiarity with options. They are typically less complicated than most structured products but are structured similarly. Both structured products and options feature an underlying asset and a contractual agreement regarding the performance of that asset. Moreover, options are a popular ingredient in structured products, frequently accompanied by principal guarantee. A basic overview of options will help to further demystify the world of structured products to interested investors.
An option is a contractual agreement between a buyer and a seller that gives the buyer the right but not the obligation to buy or sell a financial instrument during the duration of the contract. The seller is legally obligated to buy or sell the financial instrument if the buyer executes the option. An option in which a buyer purchases the right to sell a financial instrument is called a put option. An option in which the right to buy is purchased is called a call option. In a put option, the buyer is betting against the price of an asset. In a call option, the buyer is betting that the price will increase. Options are commonly named after a geographical location. The distinguishing characteristics between these different categories of options however have nothing to do with geography.
European options are one common type of option. Generally, most European options are purchased over the counter rather than on exchanges. This means simply that a European option is more likely to be purchased on arrangement through a broker or network of dealers than on an option exchange such as the Chicago Board Options Exchange (CBOE). What most sharply distinguishes a European option from other option types, most notably the American option, is that its execution date is fixed by the contract. It is possible with European options that the asset could reach an optimal price midway through the period of the contract and recede to a less than optimal level before the execution. There is no distinct advantage or disadvantage to this feature of European options compared to different option types.
American style options are roughly the opposite of a European options. They are typically traded on an exchange rather than over the counter. Most exchange-traded options are American style. Additionally, American style options give the buyer the right to execute at any point during the duration of the contract. This freedom gives them a higher value than European style options. American and European style options are the two main types of options. For both types, buyers can choose to execute, not execute, or sell the option.
Additional types of options modify one of these two option types. The Bermuda option combines American and European options by making it so that buyers can execute at predetermined dates during the duration of the option. For example, a Bermuda option may allow a buyer to execute on the first day of every other month during a one-year contract. This type of option combines control and relative certainty on the part of the issuer and flexibility without the high price of an American option to the buyer.
Options like the Bermuda option that differ from either of the two main types of options are categorized broadly as exotic options. A barrier option’s payout is based on whether or not the price of the underlying asset reaches or surpasses a predetermined level. An Asian option, also known as an average option, depends on the average price of an underlying asset over a period of time. There are even compound options for which the underlying asset is another option. The world of exotic options can be thoroughly exotic. AVC Advisory financial consultants can further clarify the nuances, risks, and potential rewards of different styles of option for those investors interested in exploring options or structured products.