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As a result of increased liquidity in the dry FFA market, freight options were introduced in 1997. They started with large European shipowners selling calls on forward positions on delivery of newbuildings.
An option gives the buyer the right but not the obligation to buy (or alternatively sell) the underlying market. The buyer of the option pays a premium to the seller for this right. His liabilities stop there. The seller of the option receives the premium and potentially has an unlimited exposure to the vagaries of the market.
Buying an option can be compared to buying insurance. The maximum loss that can occur is quantified by the premium that is paid.
Options prices are quoted at a level that option sellers believe compensates them for the risk of selling options. Sellers exchange an element of risk for a premium (the amount of money paid to the seller). Option sellers retain the premium and some specific obligations. That may be sufficient reason, but if they already own a position (for example shipowners long of tonnage), their risk is further offset by the underlying asset.
Dry and tanker freight options are European-averaged and can be placed for any period up to five years ahead. They are traded in almost exactly the same way as the underlying FFAs. They can be traded bilaterally or cleared – although like the FFA market, the majority are cleared through a clearing house.
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All options have finite lives. Most FFA options are European-averaged (or Asian) and are automatically settled at the end of the contract. No prior notification is required. An option is finally either settled in favour of the buyer or abandoned (with the seller retaining the premium).