Let's have a look into financial options, an area of derivatives that is in stock contrast to the world of forwards, futures and swaps. In those products, we enter into binding contractual agreements that compel both parties to adhere to the contract's terms, irrespective of the shift to market tides since the agreement was entered into. In contrast, an option is a financial agreement that gives its holder the right, but not the obligation to purchase in the case of a call option or sell in the case of a put option, a designated asset at a pre-agreed strike price, also referred to as the exercise price, either within a set timeframe or on a specific expiration date. This distinction introduces a level of strategic flexibility for the option holder, enabling them to navigate according to prevailing market conditions. The optionality creates asymmetry where the option buyer has the power of choice, while the seller still has an obligation. Should the buyer opt to exercise their option to compensate the seller of the option for this asymmetrical relationship, the option buyer must pay a non-refundable option premium to purchase the option in the first place. Now let's have a look at an example to illustrate the concept of options. Imagine an asset with no dividend payouts, which is currently valued at 100 in the spot market and where 12 month interest rates stand at 5%. A trader acquires a 12 month call option with a 105 strike price at a premium of 7.90. This is referred to as a long call option position where the term long relates to the purchasing of the option and call relates to the ability to buy the underlying asset. Let's think about how the traders profit and loss or P&L might look after 12 months under various market conditions assuming this is a cash-settled option. If on expiration the assets price is exactly 105, the options value is 0 as the strike price matches the spot price, and therefore the option does not offer any economic value to the holder. However, this doesn't translate into a 0 P&L for our trader. Remember, the traders already spent 7.90 on the premium to buy the option in the first place, which setting aside the concept of a time value of money for simplicity would reflect a loss equal to the premium paid.

And what if the market price is below the strike? Press say 100 or 90 or lower here. The options designed comes into its own as the holder would opt to not exercise their right to purchase at a higher strike price. It would make no sense to buy the asset for 105 as the option allows you to do when you can buy the asset for less in the open market, so the option expires worthless. However, the trader's loss remains confined to the initial premium outlay of 7.90. This feature limits the Option buyer's potential loss exclusively to the premium paid, no matter the extent to which the assets price declines. In our example, the loss will never be more than 7.90, however, the underlying assets price might increase and end up above the strike price at expiration. Let's think about what would happen if the underlying asset is at 1.10. At expiry, the call option holder would exercise their right to buy the underlying asset for 105 of the option contract. Despite the asset being worth 110 in the open market, this provides them with a gain of 5. Assuming that this is a cash settled option, this would result in a 5 cash settlement. The difference between the market price and the strike price being paid by the option seller. However, this doesn't result in a gain of five. The 7.90 premium paid upfront must first be covered before any profit is realized. The net position here would be a loss of 2.90.

The breakeven point for the trader where they make no gain and no loss is where the assets price at expiry is 112.90. This can be calculated as the sum of the strike price, 105 and the premium 7.90 at any price for the underlying asset at expiry above this threshold, profits would begin to accrue. For instance, at an underlying asset price of 120 the option yields a 15 cash settlement. The difference between the 1.20 asset price and the exercise price of 105, which would translate into a net profit of 7.10 after the premium of 7.90 is taken into account, as you can see in the diagram, as the price of the underlying asset at maturity increases. So too does the profits made on the trade.