The holder of an option has the right to buy or sell the underlying asset at a specified price, while the seller of the option has the potential obligation to buy or sell the underlying asset. Learn what it means to open a position and how it can be closed.
Understand the consequences of buying and selling options.
Positioning Management explained in detail
How does an option work
A right to buy or an obligation to sell and vice versa.
What is an option? An option gives the buyer the right, during a fixed period, to buy (call option) or sell (put option) a specified amount of the underlying asset at a fixed price. On Euronext’s derivatives market, options are traded on various underlying assets such as shares, indices, and commodities. The underlying asset of an options contract is also known as the “Underlying Value”.
An investor who buys an option concludes what is known as an opening buy transaction, and is called the buyer. An opening buy transaction creates a long position in call or put options. Each option gives the holder the right to buy (call option) or sell (put option) a specified amount of the underlying value at a fixed price. The investor can liquidate this position by means of a closing sell transaction.
An investor who sells an option is called the writer. The writer concludes an opening sell transaction which creates a short position in call or put options. The writer of an option has the obligation, if assigned, to sell (call option) or buy (put option) a specified amount of the underlying value at a fixed price. Note that exercising some types of options does not result in physical delivery of the underlying value but in cash settlement.
Open positions can be closed before maturity
An investor who has previously sold (written) an option, but wants to be released from the resulting obligation to buy or sell the underlying value, can do so by means of a closing buy transaction. Writers can do this up until the point that they have been assigned, i.e. called upon to meet their obligations. When investors write call options on an underlying value that they own (and are therefore agreeing to sell at a fixed price if assigned to do so), these options are regarded as covered options.
Investors can also write call options without actually owning the underlying value. If the option is then exercised, the writer has to buy the underlying value before delivering it to the buyer. In this case, the option is called a naked option. Written put options are always naked options. Investors are only allowed to write naked options if they deposit sufficient collateral (margin).
Exercise of an option leads to setlement
After being exercised, options can be settled in two ways: by means of either physical delivery or cash settlement. In most cases, exercising an option results in the physical delivery of the underlying value. However, a number of Euronext options are settled in cash on the basis of the difference between the exercise price and the settlement price. The form of settlement used for each option class and, where applicable, the method used to calculate the settlement price, is detailed in the contract specifications.
Netting, the offsetting of opposing positions
There is no direct relationship between the buyer and the writer of an option that is traded on Euronext. Instead, the clearing acts as counterparty for both buyer and seller in each transaction and as such mitigates the risk of the transaction for both.
The clearing has the role of “Central Counterparty”, often referred to as CCP. You do not have to worry if payments are made or the underlying value gets delivered. The clearing secures the proper handling and processing of the rights and obligations involved in the transfer of premiums and the settlement or delivery of the option.
As the clearing fulfils this role in all exchange traded options it also allows to calculate the net result of your option transactions. This process is called netting.