When you begin to trade options, the first thing you will come across is different types of option contracts. In this article we will discuss the different types of options that you find when trading options.
An option is a contract between two parties in which the buyer purchases the right to buy or sell something from the seller within a specified amount of time at a specified price. But the seller has the obligation to buy or sell to the buyer if the buyer exercises its right.
They are called options as they are contracts with specified terms that give the buyer the right but not the obligation to buy or sell an asset at a specific price (the strike price) on or before a certain date (the expiration date).
Options are an important part of stock markets that allow traders to make a profit from Index, stocks, commodities, and other instruments with lower funds. However, Options contracts have an expiration date, after which they are terminated and price goes zero, it’s like an ice cream either you have it or it will melt.
They can help to protect investments against adverse price changes, they can be used to hedge a long stock position and reduce that position’s exposure to downside risk. If you own stock in Company X, you could buy an put option, giving you the right but not the obligation to sell 100 shares of Company X for a set price for up to a specific date.
Options are primarily used for reducing risk but can be used for purposes that are more speculative. They can provide a great way to gain exposure to the potential upside of an underlying company without buying shares directly. Most people don’t have time for the high maintenance of being an active option trader.
But what about if you don’t want to be an option trader? What about just using options for high probability trade setups that turn into big winners? Buying options is a great way to make your investments a lot more interesting and give yourself a chance to really make big money. Selling options is not nearly as glamorous, but it can be very profitable if you know the limitations and then stay within them.
Option strategies are also used for different purposes.
There are two major types of options you can trade. First, the calls and second, the puts. Someone will ask if this is confusing or not. The answer is no because they both have their own set of terms that only make sense if you understand what they mean.
A Call option is a contract giving the buyer of the call option the right to buy an agreed quantity of underlying security, at an agreed price, on or before a specified date. Buying a call option is one of the best ways to profit from rising stock prices.
A put option is a contract that gives a buyer the right to sell a specific underlying asset at a specified price during a specified period of time. Buying a put option is one of the best ways to profit from falling stock prices.
Options can also be classified on the exercising style. These options outline the timeframe when the option buyer can exercise their option contract rights.
An American option is an options contract that allows buyers to exercise the option rights at any time before and including the day of expiration. An American-style option allows investors to capture profit as soon as the stock price moves favorably. American options are often exercised before an expiry. Since buyers have the right to exercise their options at any point during the life of the contract, American options are more costly than the European options.
A European option contract limits exercise to its expiration date. It means, if the underlying security such as a stock has moved in price, an investor would not be able to exercise the option early. Exercise will only take place on the date of option maturity. A European option is a version of an options contract that limits rights exercise to only the day of expiration.
Investors usually don’t have a choice of buying either the American or the European option and most indexes use European options.
Here are a few examples of different types of options based on underlying security:
The most common type of option is a stock option in which the underlying security is stock in a publicly listed company. A very popular choice amongst traders, it has the shares of a publicly listed company as its underlying security.
Quite like the stock options, instead of a particular company’s shares, the Index option is based on an index like Nifty, Bank Nifty, etc.
This option type gives the owner the right to buy or sell a specific currency at an agreed exchange rate.
In Commodity Options, the underlying asset is a commodity.
The term “premium” defines the price at which one can buy or sell a contract.
A Call option is said to be in-the-money when its underlying security is trading over the strike price of the option. A Call option is said to be out-the-money when its underlying security is trading below the strike price of the option. A Call option is said to be at-the-money when its underlying security is trading the same as the strike price of the option.
A strike price is the agreed upon price at which an underlying security can be purchased (call option) or sold (put option) by the option holder. Strike price is an important concept in options trading. It reflects how much a call or put option will cost you if exercised by the seller.
The contract size of an option is the number of shares (or contracts in futures) it controls.
Expiration date is the last day an option may be exercised. All option positions bought by the investor expire on the day. On this day, if it’s a long call port, the investor expects the price of the underlying asset to be higher than current market price and would want to exercise their right to buy stock at a lower strike.
Weekly options expire every week but there are a few subtle things about these options that you should know before you trade them.
Monthly options are options that expire every month. There are four expiration cycles for monthly stock options. Monthly Options are the most popular of all options for many traders because of their versatility.
A quarter is a period of four months. Thus, quarterly options expire in the last month of the quarter. A quarterly option can be exercised until the end of the last month in its time frame and will expire at the end of that month if it is not exercised by the buyer.
Intrinsic value is what makes an option worth something. If you are lucky enough to have a call option with intrinsic value, then you have a choice: Either you can use it to buy the asset at the strike price, or you can sell the option and realize your profit from that. Intrinsic value that gives an option buyer something’s worth more than just the time premium.
The settlement of those options can affect the ownership even while they are still open. You want to be sure that the settlement has taken place correctly and in accordance with your arrangement with your counterparty. Therefore, the time of the settlement or closing of an options contract depends on what kind of option you have bought and when you exercised it for withdrawal of funds.
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