What Is a Seller's Option?
A seller's option, often used in conjunction with a forward contract, gives the seller the right to choose some of the specifications of a derivatives agreement—such as the time and place of delivery of the underlying security or commodity.
- A seller's option grants the seller of a forward the right to choose some of the contract's specifications.
- These often include the time and place of delivery of the underlying security or commodity covered by the contract.
- A seller's option is useful for ensuring physical delivery can be made by sellers needing a bit of flexibility.
- A seller's option also comes into play in bond derivatives markets with cheapest to deliver (CTD) contracts.
Understanding a Seller's Option
A seller's option is most commonly employed in forward contracts, or "forwards," for physical commodities. It is helpful 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 futures contract is a legal agreement to buy or sell a particular commodity or security at a predetermined price at a specified time in the future. They are standardized for quality and quantity to facilitate trading on a futures exchange. In contrast, a forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. Forward contracts can be tailored to a specific commodity, amount, and delivery date. They do not trade on a centralized exchange and are considered over-the-counter (OTC) instruments.
When it comes to agricultural and natural resource commodities, collecting suitable amounts of the goods and providing transportation to deliver them can be a very complicated and costly process.
For example, a forward contract for corn can represent 5,000 bushels and a contract for oil can deal with 10,000 barrels. Since hedgers—a forward contract's non-standardized nature makes it particularly apt for hedging—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 or oil barrels during a single delivery window.
Giving contract sellers a little bit of leeway can alleviate some of the difficulties involved with delivery logistics. They may opt to deliver the goods in separate batches, for example. A seller's option may also provide some flexibility with regard to the exact settlement date and delivery date.
However, the choices about the delivered commodity or asset's quality and delivery specifications must fit within any pre-established limits imposed by the terms of the contract—for example, a contract might specify a limit to any extension of the delivery date. The contract must be clearly identified as being a seller's option at the time it's drawn up. And, of course, the buyer must agree to the seller's proposed options and adjustments.
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.
Special Considerations: Cheapest to Deliver
A seller's option also comes into play in bond derivatives markets with cheapest to deliver (CTD) contracts. It gives the short in a forward contract the ability to work with the long side of the contract to ensure delivery is fulfilled, but in which the seller can choose exactly what to deliver, within the scope of the contract.
This feature is common in futures contracts for U.S. Treasuries, 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 security to deliver 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 security in a futures contract, the market generally prices these futures contracts based on the CTD security anyway.