Options are exactly as their name suggests, they provide the purchaser with an option to buy or sell an underlying financial security. Although this may sound limiting, options are amazing tools that can provide both the seller of the option and the buyer of the option with the ability to protect or hedge current stock positions, reduce their market risk, or generate additional income.
Options can be issued on stocks, indices and currency.
An option is defined by a contract between the buyer of the option and the seller of the option. The contract gives the buyer of the option the right to buy or sell a set amount of stock at a specific price on or before a specific date.
The option buyer pays the seller a premium in order to acquire this right. The right to buy a stocks/security is known as ‘Call’, while the right to sell is called ‘Put’.
They can be used as:
- Leverage: Options help you profit from changes in stock prices without putting down the full price of the stocks.
- Hedging: Option can also be used to protect from fluctuations in the price of stocks.
TYPES OF OPTIONS
Call options give the buyer the right but not the obligation to buy the underlying stock at a specified price on or before a specified date (expiry date). The price specified in the option contract is referred to as a strike price or exercise price.
As a buyer of call options, you are hoping for the value of the underlying stock to rise. An increase in the price of the underlying stock will result in an increase in the value of your options.
The seller of call options receives a premium for taking on the obligation to sell the underlying stock to the buyer of the options at the strike price if the buyer decides to exercise the option before expiry.
Put options give the buyer the right (but not the obligation) to sell the underlying stock at a specified price (strike price) on or before the expiry date. As a buyer of a put option, you are hoping the value of the underlying stock will fall as this will result in an increase in the value of your options.
The seller of a put option receives a premium for granting this right to the buyer. If the option is exercised, the option seller must buy the underlying stock at the strike price.
OPTION RELATED TERMS
When you are trading in the derivatives segment, you will come across many terms that may seem unfamiliar. Here are some options-related key terms.
Premium – The premium is the price at which the option is bought and sold between a buyer and seller.
Strike Price / Exercise Price: The pre-decided price at which the asset can be bought or sold.
The Expiry date-Every option has a limited life that is determined by the option expiry date. The expiry date is the last day on which the option can be traded (bought or sold) and is the date on which all unexercised options expire
LOT SIZE:– Lot size refers to a fixed number of units of the underlying asset that form part of a single F&O contract. The standard lot size is different for each stock and is decided by the exchange on which the stock is traded.
OPEN INTEREST: Open Interest refers to the total number of outstanding positions on a particular options contract across all participants in the market at any given point of time. Open Interest becomes nil past the expiration date for a particular contract.