Options Trading

Introduction to Options Trading

Options are one of the most popular and commonly traded financial products. Being very versatile in nature, they are used in speculation and hedging alike. There are many types of options in use today, ranging from simple to more exotic versions.

Definition

The options can be simply defined as a contract that gives the right, but not the obligation, to its owner to buy or sell an underlying asset at a specific price within a specific time.

Explanation

From the above definition, it can be derived that the option gives its holder the choice to enter a transaction or cancel it within the stated period on paying a certain amount in advance.  It’s like giving token amount to reserve a car and later have the choice to make full payment and own the car within an agreed period or lose the token amount and cancel the purchase. In this scenario, if the buyer judged the car to be good and worth the value, he pays the rest of the amount and owns the car making a smart choice. On the other hand, if the buyer decides that car is not worth the money, then he can opt out of the purchase and save himself from a potential loss by just losing the token amount he paid in advance.

Types of options

Options differ from other financial products like futures, in a number of ways. For example, in futures we don’t pay any premium upfront, but the possibility of loss generated by that trade once entered is unlimited, whereas in options, the maximum possible loss generated is the premium paid in advance. They are broadly divided into two categories, Calls and Puts:

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a financial product (stocks, commodities, indices, etc.). Buyers of calls hope that the underlying asset will increase substantially before the expiry.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are similar to having a short position on a financial product (stocks, commodities, indices, etc.). Buyers of puts hope that the price of the underlying asset will fall before the expiry.

Four basic combinations can be made out of put and calls. Buyer of put, seller of put, buyer of call and seller of call.

Styles of options

There are two styles in use:

American style: An option that can be exercised by its buyer any time until exercise date is called American style option.

European style: An option in which the buyer can exercise his right only on the exercise date is called a European style option.

Basic terms

Premium: This is the premium that is paid by the buyer of the option to the seller of the option while entering the contract.

Strike Price: The price at which the buyer of the option agrees to buy (put) or agrees to sell (call) the underlying asset is called strike price.

Exercise date: The last date on which the option can be executed by the option owner is called the exercise date. It should be noted that the options contract become invalid on expiry date and the right to exercise it ceases.

There is a variety of options available to suit everyone, ranging from simple to more complex and exotic ones. There are options on equity, bond, futures, index and commodity. You can trade most of the options with us. However, if you are interested in a particular option contract, do contact us to check its availability and other details.