What are Options in Derivatives?
Whether you trade in stocks, commodities or any other financial instrument, it can take place across a number of different platforms and in a number of different ways. However, some commonly employed trading methods have proven useful time and time again for investors looking to make a profit while carefully hedging their risks. One such investing method is an options contract.
But, 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?
To understand options trading, we must first get familiar with the concept of derivatives. Derivatives are essentially a type of financial instrument that derives their value from the changing value of an underlying asset such as stocks, commodities, currencies etc., and are set between two or more parties. Therefore, as the price of the underlying asset changes in the market, the overall value of the derivative contract 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, which you will learn about below.
What Are Options?
An Options contract is essentially a type of agreement between two parties, whereby the buyer has the right 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 contract.
- 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.
- Premium: This refers to the amount that the buyer pays to the seller of the options contract and the underlying asset to avail the benefits of the options contract. It is the market price of the options contract itself.
- Expiration Date: This refers to the future date until which an options contract can be exercised by the investor. Beyond the expiration date, the options contract will expire worthlessly.
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, investors also invest in an options contract to hedge a trading position in the market.
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, also called the Options writer. The option holders, therefore, make a profit if the value of the asset rises in the future. This is because the call option allows them to buy the asset at a much lower price and then sell in the market for its current higher price.
For example, suppose you purchase a call option for 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 options holders the right, but not the obligation to sell the asset at the set strike price any time before the expiration date. If the value of the asset falls in the future, the call option gives holders the choice to sell the asset at the agreed-upon higher price, thereby minimising overall risk.
For example, let’s assume you purchase a put option for 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 can choose between exercising the contract or not.
Benefits And Features Of Options Derivatives
Let us take a look at some of its most essential features and the benefits they provide:
- If you are looking to invest in stocks, one of the greatest benefits of trading in options derivatives is that you can take a position in the market with a lower amount than directly buying stocks. It is therefore a more economical way to speculate on stock prices.
- Option derivatives can be utilised by investors to protect their portfolios against risks. As there are no direct transactions with the assets themselves, the investor gets to minimise their risk exposure and often, the only loss sustained is that of the option premium itself.
- The world of options trading is a versatile landscape and provides opportunities to both buyers and sellers of assets to make a wide variety of investments based on their market speculations. As an options trader, you can choose from buying call options, selling call options, buying put options and selling put options - each with its range of risks and profits.