Introduction
Options are a type of derivative that helps you generate income, mitigate risks, and speculate about the market’s future direction. They enable you to buy a high-value underlying asset with a much lower initial investment. However, you must use them cautiously after grasping the basic concepts, their functioning, and their different types.
Defining options
Options refer to a financial instrument derived from an underlying asset's value, such as stocks, commodities, exchange-traded funds, currency pairs, and indexes.
The seller writes an options contract to give the buyer the right to buy or sell the underlying asset at a pre-determined price in the future. Unlike futures contracts, the option contract holder has the right but is not obligated to exercise the contract. The seller of an options contract collects a premium from the buyer for granting the contract.
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Every options contract specifies an expiration date by which the holder or trader needs to exercise the option. A price is also stated on the contract and is known as the strike price. You can trade options on online trading platforms or through offline brokers.
Types of options
There are two types of option contracts - call option or put option.
With a call option, the buyer has the right, not the obligation, to buy the underlying security at a pre-determined price within a specified date. The specified date is the expiration date, and the pre-determined price is the strike price.
Generally, investors use call options when the value of the underlying asset is expected to rise. Buying a call option is identified as a long-call strategy, whereas selling a call option is known as a short-call strategy.
You earn a profit on your call option only when it satisfies the following criterion.
Spot Price - Strike Price > Premium Paid
A put option grants the contract holder or buyer the right, not the obligation, to sell the underlying asset at a pre-determined price. There are expiry dates for put options as well. You must exercise the contract on or before the expiration and pay a premium to the options seller.
An investor uses a put option when the underlying asset's price is likely to decline. By buying a put option, you can sell the asset, such as a commodity, stock, index, or currency pair, at a higher price than the existing market price. This strategy protects you from potential losses.
When you buy a put option, it is considered a long put strategy, but when you sell a put option, it is a short put strategy.
How do options work?
Options are useful tools that let you leverage price movements while managing risk. Put options allow you to sell contracts at a pre-determined price, while call options permit buying at a pre-determined price. These types of derivatives provide flexibility to earn returns from upward and downward market fluctuations. Many investors use them to earn income through premiums and hedging.
Key components of an options contract
The key components of an options contract are described below.
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Strike price: The strike price is the pre-determined price at which you can buy (call options) or sell (put options) the underlying asset. It is a defined reference point for estimating potential profits or losses.
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Expiration date: Options come with a definite expiration date, after which the contract is invalid.
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Contract size: Options are standardised in terms of contract size, which enumerates the quantity of the underlying asset included in one contract.
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Premium: An options buyer must pay a premium to an options seller to gain the right to execute trading activity.
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Hedging: Options can be used for different purposes, including hedging. They serve as insurance against potential losses in the underlying asset.
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Intrinsic value and time value: These values are the essential components of the price of an options contract. Intrinsic value refers to the difference between the underlying asset’s current market price and strike price, whereas time value is the extra premium paid over intrinsic value. It considers factors like market volatility and time remaining until expiration.
Conclusion
Options are flexible investment vehicles. They give you several trading opportunities in different markets. Before you start options trading, you must analyse the associated risks and make investment decisions based on your risk appetite and investment style.
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