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.
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