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NO17 - What are Options Contracts?

"The derivatives markets are one of the largest. They are also the most volatile because they are primarily used as hedging products. It is not just speculators and day traders but also consumers and suppliers who make use of the derivative markets. Among the many types of derivative products, options are one of the most widely used hedging contracts. An option contract allows the participant to hedge their bets made in the underlying spot markets. In this article we give you an introduction to the options contracts and how traders use options such as stock options or forex options in order to hedge the volatility in the underlying markets. We also focus on the different types of options that are available as well give you a basic introduction to how options work. Chances are that you might not be using options that much, but they are a product that you should know if you wish to advance your career as a trader and find the need to hedge your positions."

The flexibility of the financial markets is that you can use derivatives to hedge your exposure to the underlying markets. Derivatives are nothing but financial products that are derived from the underlying cash or spot markets.

Using derivatives, traders can hedge the risk. This might sound a bit complex, but it is very simple. Let’s say you have a long position in a stock. You expect the price to appreciate in the next three months, but you are also concerned that the stock price might drop.

You can only sell the positions that you hold when trading stocks. Thus, you can buy an options contract that will reward you if the price of the stock falls within the contract period. This is nothing but a hedge and the cost of hedging using options is cheaper.

At the end, you continue to maintain your long position in the stock but you are also hedged which will compensate you if the stock falls in value during the course of the option contract.

What is an option contract?

An option contract is a derivative product where the buyer of the contract has the right but is not obliged to exercise his right at the end of a contract. In an option contract, the buyer and the seller agree to the price of the asset at a future date.

For example, if you think that a stock which is currently trading at $5 will rise to $10 in 30 days, then you buy an option contract. The strike price is nothing but $30. Thus, when the strike price is reached on the end of the contract, which is the expiry date, you as a buyer have the right to exercise the option.

In effect, you are purchasing the stock option at a cheaper price and expecting delivery of the underlying when the strike price is higher. But as mentioned, as a buyer you are under no obligation to exercise the right.

This means that if the option failed to reach the strike price, you can simply walk away. The only loss you incurred is the premium that you pay at the beginning.

Because option sellers are taking a risk, they charge a premium. The premium is based on two factors, known as time decay. Option contracts that have a longer expiry date are cheaper compared to options that have a closer expiry date.

Types of options contracts

There are two types of options contracts, these are known as a PUT option or a CALL option.

A PUT option is bought when the investor believes that the price of the underlying security will rise. Likewise, a CALL option is bought when the investor believes that the price of the underlying security will fall.

The seller of the PUT and CALL option charges a premium regardless of the direction. This is because the seller must be obliged to deliver the underlying security to you, if you as the buyer of the option decide to exercise your right.

Typically though, the option premium is much lower compared to an outright purchase of the underlying security.

The general terms of the trade with options contracts is that the premium can be settled two days after purchase, known as T+2 or you can settle the premium on the expiration day.

Option contract styles

Within the options contracts, there are again two different options.

European Option: The European option style allows the buyer to exercise their right only after expiry.
American Option: The American option style allows the buyer to exercise their right any point up to the expiry time.

As you can see, the American option contracts have a distinct advantage for the buyer because they do not have to wait until the option reaches its expiry. As and when the strike price is reached, the buyer can exercise their right and get delivery of the underlying option.

Option contract instruments

There are numerous underlying securities that you can trade options with. However, most of the option contracts are geared towards the equity markets. Therefore, you can buy stock options and options on stock indexes such as the S&P500 or the Dow Jones.

There are also forex options. Forex options allow you to buy or sell PUT and CALL options. Just like you trade a currency pair, forex option contracts allow you to purchase or sell PUT and CALL options on currency pairs.

Within the options contracts, there are also numerous other exotic options. Some examples include convertible forward option contracts, binary options contracts, digital option contracts and average rate forward contracts to cite a few examples.

Read 975 times Last modified on Sunday, 12 May 2019 07:51