After much anticipation and discussion, we finally got derivatives in Zimbabwe. The Financial Securities Exchange (Finsec) introduced derivatives in the form of options and futures contracts on limited securities available on the ZSE. We promised to take an in-depth look at these things and what they mean for Zimbabwe’s capital markets and we will first take a look at Options. Options are one of the simpler yet more exciting type of derivative contracts in existence.
Options
An options contract is an agreement between two parties that gives one of the parties the right (but not the option) to either buy or sell an asset or underlying item at a future date at a specified price. To put that in simple English an option contract gives for example someone who wants to buy something, the right to buy it for an agreed price in the future. While the option is a solid commitment for the person selling in this case, the buyer has the option (pun intended) to not take up the right. You can think of an option as a right to decide or a contingent purchase contract. You can have options go the other way, where some agrees on a sale price for a date in the future and chooses whether or not to sell it. In this case, the buyer is locked in depending on the seller’s decision. That’s the easy part out of the way.
Options terminology
Let’s do a run-through of the terminology used in options to understand them a little better practically.
Call
You will see the term “call option”, which simply means an option to buy. Think about this as calling for an item to be brought to you.
Put
“Put options” as you might have surmised are options to sell. So when someone says put option it is like an agreement to give an underlying or put it in someone else’s possession.
European
When it comes to options contracts they usually have a duration. This can be in days, weeks or months. The term European options refer to one way of closing options for contracts. In European options, the person who has the choice/option can only take action on the maturity (last day) of the contract. American options (not offered by Finsec) allow taking action at any point along the duration.
Writer/Buyer
As an option is a contract there has to be an originator of the contract and a 2nd party that enters the agreement with them. The person who originates a contract is called the writer. This is regardless of who is buying or selling in the contract. The 2nd party is known as the option buyer, distinct from the buyer.
Margin
Of course, people aren’t dishing out option contracts for free. This right to either call or put comes at a cost and this cost is called the margin. This is a payment made to secure the contract. With Options, you will be charged this upfront to secure the contract.
Strike
Strike or strike price refers to the price agreed upon in the contract. So when we agree to a call option for Delta shares at $330, $330 is the strike or strike price.
Risk-Free Rate
Without making this discussion overly complicated the risk-free rate is the rate at which your money would otherwise be saved without risk. This is important because when we look at finance we consider the cost of capital. Where there does no cost of capital we look at the opportunity cost of capital, in this case, the risk-free interest rate. Simply put the higher the interest rate the more expensive call options will be while the inverse is true for put options.
The options market is still new and there are a few things to learn. This will give you a basic understanding and help you connect the terminology to the function of options contracts.
