What are Options in Derivatives?
Trading, be it in stocks, commodities or any other financial market, can take place across a number of different platforms and in a number of different ways. However, there are some commonly employed methods of trading that prove useful time and time again for parties looking to make profit while carefully hedging their risks. One of these methods is that of options contract.
So, exactly what are options, what is options trading and how does it work? To understand these concepts better, let us take a closer look:
What Are Derivatives?
In order to understand options trading, we must first get familiar with the concept of derivatives. Derivatives are essentially a type of financial instrument that derives its value not from itself, but from the changing value of an underlying asset. Therefore, as the price of the underlying asset changes in the market, the overall value of the derivative changes with it. When trading in derivatives, people essentially trade in agreements or contracts that stipulate the purchase or sale of an asset at an agreed upon price and a specific date. Options trading is essentially a type of derivatives trading.
What Are Options?
Now that we understand the concept of derivatives, we can get a better perspective on how options and options contracts work.
Options, or options contracts, are essentially a type of agreement between two parties, whereby the buyer has the option but not the obligation to buy or sell an underlying asset. The asset must be bought or sold - depending on the type of options contract- on the specific date and at a predetermined asset price. Some of the essential terms that are often used in options trading are:
- Lot Size: This refers to the standard quantity or units of the underlying asset that is included in the options contact.
- Strike Prize: Also known as exercise price, this is the price of the asset at which the two parties agree to buy or sell the underlying asset, in an options contract.
- Premium: This refers to the amount that the buyer pays to the seller of the asset in order to avail the benefits of the options contract. It is essentially the market price of the options contract itself.
- Expiration Date: This refers to the future date by which an options contract must be exercised by the investor. Beyond the expiration date, the options contract will expire worthless.
How Is Options Trading Done?
Anytime a party enters into an options contract, they typically do so either because they think that the price of an asset is set to rise or that the price of an asset is set to fall. Apart from speculating on the price of the asset to go up or down, you can also invest in an options contract in order to hedge a trading position in the market.
In order to understand how options trading is done in the market, you must be familiar with the type of options derivatives that are employed. Here are the two major types of options contracts:
A call option is a type of options contract that gives the holder the right, but not the obligation to buy the asset at the agreed upon strike price before the expiration date. The call option can be bought by the investor by paying a premium upfront to the seller. The option holder therefore, makes a profit if the value of the asset rises in the future. This is because the call option allows him to buy the asset at a much lower price and then sell in the market for its current higher price.
Let us put this in perspective with a call options trading example. Say, you purchase a call option for a stock at a strike price of Rs 200 and the expiration date is in two months. If within that period, the stock price rises to Rs 240, you can still buy the stock at Rs 200 due to the call option and then sell it to make a profit of Rs 240-200 = Rs 40.
A put option is a type of options contract that gives the holder the right, but not the obligation to sell the asset at the agreed upon strike price any time before the expiration date. If the value of the asset falls in the future, the call option gives him the choice to sell the asset at the agreed upon higher price and thereby minimize his risks.
Let us understand this with a put options trading example. Let’s assume you purchase a put option for a stock at a strike price of Rs 200 and the expiration date is in a month. If within that period, the stock price falls to Rs 180, you can still choose to sell the stock at Rs 200. On the other hand, if the price of the stock rises above Rs 200, you still have no obligation to sell it or can still sell it at the current market price.