CDS options are a type of financial derivative that provides the buyer with the right, but not the obligation, to buy or sell a credit default swap (CDS) at a predetermined price (strike price) on or before a specified date (expiration date). There are two main types of CDS options:
- CDS call options: A CDS call option gives the buyer the right to buy a CDS at a predetermined price (strike price) on or before a specified date (expiration date). If the creditworthiness of the underlying entity deteriorates and the price of the CDS rises above the strike price, the buyer of the CDS call option can exercise the option and buy the CDS at the lower strike price. The buyer can then sell the CDS at the higher market price, realizing a profit.
- CDS put options: A CDS put option gives the buyer the right to sell a CDS at a predetermined price (strike price) on or before a specified date (expiration date). If the creditworthiness of the underlying entity improves and the price of the CDS falls below the strike price, the buyer of the CDS put option can exercise the option and sell the CDS at the higher strike price. The buyer can then buy the CDS at the lower market price, realizing a profit.
CDS options are often used by investors to hedge against or speculate on changes in the creditworthiness of a particular entity or portfolio of entities. They can also be used to construct more complex trading strategies, such as delta-neutral trading, where the investor aims to profit from changes in the price of the CDS option rather than the underlying CDS.