DEFINITION of Seller's Option
A seller's option is the right of a forward contract seller to choose some of the specifications of the underlying security or commodity to be delivered. The choices about the delivered commodity's or asset's quality and delivery specifications must fit within the pre-established limits imposed by the terms of the contract. A seller's option is useful for making good on physical delivery without having to worry so much about the stringent specifications set out in standardized contracts such as listed futures contracts. A seller's option may also provide some flexibility with regard to the exact settlement date and delivery date.
A seller's option may also refer to a put option, since the owner of a put has the right to sell the underlying security at a specified price.
BREAKING DOWN Seller's Option
A seller's option gives the short in a forward contract the ability to work with the long side of the contract to ensure delivery is fulfilled, but where the seller can choose exactly what to deliver, within the scope of the contract.
A seller's option is most commonly employed in forwards on physical commodities. For some commodities, such as rice and oil, collecting suitable amounts of a commodity and providing the transportation can be a very complicated and indeed costly process. For example, a forward contract for corn can represent 5,000 bushels. Since hedgers tend to buy large numbers of contracts at a given time, a forward contract seller might have to deliver hundreds of thousands of corn bushels during a single delivery window. Giving contract sellers a little bit of leeway can alleviate some of the difficulties involved with delivery logistics.
Seller's Option: Cheapest to Deliver in Bond Futures
A seller's option also comes into play with in bond derivatives markets with cheapest to deliver (CTD) contracts. This feature is common in treasury bond futures contracts, which will typically specify that any qualified treasury bond can be delivered so long as it is within a certain maturity range and has a certain coupon rate. Determining the cheapest to deliver security is important for the short position, and this seller's option makes it advantageous for the seller to pick a specific security to deliver over another in their book in order to maximize their profit. However, since it is to be assumed that the short position will always provide the cheapest to deliver security, the market generally prices these futures contracts based on the cheapest to delivery security anyway.