Understanding Options
Options are financial contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified period. The underlying asset can be a stock, bond, currency, or commodity. Options have to be purchased by paying an extra amount known as the premium. There are two types of options: call options and put options. A call option is a contract that gives the holder the right to buy an underlying asset at a predetermined price, while a put option is a contract that gives the holder the right to sell an underlying asset at a predetermined price.
Call options are used by investors who believe that the price of the underlying asset will rise in the future. They buy call options to lock in the price at which they can buy the asset. If the price of the asset increases, they can exercise their option and buy the asset at a lower price than the market price. If the price of the asset does not increase, they can let their option expire and only lose the premium they paid for the option.
Put options are used by investors who believe that the price of the underlying asset will fall in the future. They buy put options to lock in the price at which they can sell the asset. If the price of the asset decreases, they can exercise their option and sell the asset at a higher price than the market price. If the price of the asset does not decrease, they can let their option expire and only lose the premium they paid for the option.
CLASSIFICATION BASED ON EXPIRATION DATE
Options can also be classified based on their expiration date. There are two types of options based on expiration date: European options and American options. European options can only be exercised on their expiration date, while American options can be exercised at any time before their expiration date.
CLASSIFICATION BASED ON SETTLEMENT METHOD
Options can also be classified based on their settlement method. There are two types of settlement methods: physical settlement and cash settlement. Physical settlement is when the underlying asset is delivered to the holder of the option upon exercise. Cash settlement is when the holder of the option receives cash instead of the underlying asset upon exercise.
Thus, options are financial contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified period. While the investor has to certainly pay a premium to buy these, a wise and alert investor can multiply his/her returns by Options trading. Options are financial tools that allow traders to magnify their potential profits by investing smaller amounts than what would be required to trade the underlying asset. For instance, instead of investing Rs 10,000 to buy100 shares of a Rs.100 stock, a trader could potentially invest only Rs. 2,000 in a call contract with a strike price that is 10% higher than the current market price.
Madhulika Goyal
