Options are a derivative contract which is derived from a certain underlying asset. The underlying instrument can be stocks, indices, currency or any other security.
Once, the meaning of option is understood we will look at what is an option contract. An option contract is a financial contract which gives an investor a right to either buy or sell an asset at a predetermined price by a specific date. However, it also entails a right to buy, but not an obligation.
There are two types of parties involved in an option contract, one is the buyer who is also called a holder and the other one is the seller also known as the writer.
In India, National Stock Exchange (NSE) introduced the options trading in indices on 4 June, 2001.
Initially, options were introduced for investors to hedge their positions but since options are volatile it consists of too many fluctuations and later on people started to trade options to earn money in a short time.
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Features Of Option Contracts
- Premium
The buyer also known as the holder has to pay a certain amount which is called premium for having the right to exercise an option trade. In case of losses an investor only loses that premium amount.
- Strike Price
Strike price refers to the rate at which an investor can buy or sell the underlying asset. This strike price remains fixed and cannot be changed until the expiry of the contract. There are three type of strike prices:
- In the Money contract (ITM)
- At the Money contract (ATM)
- Out of the Money contract (OTM)
- Quantity Size
The quantity size of an option contract is fixed for a specific underlying asset. If the contract size is for 50 shares then, when trade is conducted then there will be a buying and selling of 100 shares.
- Expiration Date
Every option contract comes with an expiry date. The expiry date does not change until the validity of a contract. If investors do not square off their positions until expiry date, a contract expires.
- Settlement Of An Option
There is no buying, selling or exchange of securities when an options contract is written. The contract is settled when the holder exercises his/her right to trade. In case the holder does not exercise his/her right till maturity, the contract will lapse on its own, and no settlement will be required.
- No Obligation To Buy Or Sell
In case of option contracts, the investor has the option to buy or sell the underlying asset by the expiration date but he is under no obligation to purchase or sell. If an option holder does not buy or sell, the option lapses.
Types of Option Contracts
So until now we have understood the meaning and features of option contracts. Now, in order to understand more about them, there are two types of option contract:
- Call Option
- Put Option
Call Option
Call Options is a type of an option contract in which the buyer has to pay the premium in order to place the order. In a call option an investor will be predicting that the value to the price will rise. So, a call option will give profits to the investors when the price of the underlying asset will rise. In option buying losses are limited and profits are unlimited.
In order to place an order in call option an investor has to select the expiry of the contract, then he/she will have to select the type of contract (i.e. ITM, ATM, OTM)
- In The Money Call Option- In this case the strike price is less than the current market price of the security.
- At The Money Call Option- When the strike price is lower than the current price by an amount equal to the premium paid for the call option then it is said to be at the money.
- Out Of The Call Option- When the strike price is more than the current market price of the security, a call option is considered as an out of the money call option.
Put Option
Put Options is a type of an option contract in which the holder has to pay the premium in order to place the order. In a put option an investor will be predicting that the value to the price will fall. So, a put option will give profits to the investors when the price of the underlying asset will fall. In option buying losses are limited and profits are unlimited.
In order to place an order in put option an investor has to select the expiry of the contract, then he/she will have to select the type of contract (i.e. ITM, ATM, OTM)
- In The Money Call Option- In this case the strike price is less than the current market price of the security.
- At The Money Call Option- When the strike price is lower than the current price by an amount equal to the premium paid for the call option then it is said to be at the money.
- Out Of The Call Option- When the strike price is more than the current market price of the security, a call option is considered as an out of the money call option.
Conclusion
In the end I would like to conclude this article by saying that options are a great way to earn money but at the very same time option trading is highly risky due to its extreme volatility. In order to earn from option trading it is highly important to learn about the stock market first and gain some real market experience. Beginners should never trade in options since it is highly risky and volatile.