Financial derivatives: options
These refer to the right to buy or sell a specific commodity, currency or security on a certain date in the future at an agreed price, but without the obligation to do so. The buyer and seller of the option agree on the premium to be paid by the buyer. This premium is separate from the price of the goods and is payable whether or not the buyer exercises the option. Private investors often prefer options because there is a limited risk. Unlike futures where investors are exposed to a rise or fall in the market, options allow the investor to let the right expire if market conditions are not good. By doing so, the investor has only risked the premium. This is a form of hedging (see VATFIN6400).
There are many types of options, and the underlying can be anything that is actively traded in a market where the price is not in dispute. The most widely traded are dealt with below.
Please see VATFIN6600 for contracts traded on LIFFE.
Types of options contract
This entitles the owner to buy or sell shares in a company. The trading of an option is not in itself the buying or selling of shares: the firm itself does not issue the options and receives no money for them, and the owner of the options does not receive dividends or voting rights. Only when an option is eventually exercised, will the owner acquire or sell the underlying shares.
These are traded on most commodities and set down a standard contract giving the right to purchase a certain commodity in a specified quantity, for a specified price on a certain date.
Based on the exchange rate between two currencies, a currency option is a right to buy currency in a specified quantity, for a specified price on a certain date.
Terms associated with options trading
When looking at businesses that deal in options you may come across such terms as:
- straight options
- traded options and
- put and call options.
These terms are explained in the glossary at VATFIN9000.
Determining whether a contract is a financial derivative
To help determine whether a contract is a financial derivative you should consider:
- the underlying - is the trading derived from a financial instrument (e.g. shares) or something else (e.g. a commodity)
- is the supply one of goods or services? (see VATSC03000 to help you decide this)
- are the parties members of a commodity exchange listed on the Terminal Markets Order (‘TMO’)? (Section 4 of Notice 701/9 Commodities and Terminal Markets will help you ascertain this.)
Options on item 6 contracts are item 6 securities and options on item 1 contracts are item 1 securities.
There is no further supply when an option to obtain or supply the underlying futures contract is exercised on an item 1 contract. There will be a further exempt supply of the security if the option on an item 6 contract is exercised. The contract entered into for the underlying will be a supply for VAT purposes.