Updated: Sep 16, 2020
An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options are a type of derivative product.
The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option’.
They can be used as:
Leverage: Options help you profit from changes in share prices without putting down the full price of the share. You get control over the shares without buying them outright.
Hedging: They can also be used to protect yourself from fluctuations in the price of a share and letting you buy or sell the shares at a pre-determined price for a specified period of time.
Though they have their advantages, trading in options is more complex than trading in regular shares. It calls for a good understanding of trading and investment practices as well as constant monitoring of market fluctuations to protect against losses.
Just as futures contracts minimize risks for buyers by setting a pre-determined future price for an underlying asset, options contracts do the same however, without the obligation to buy that exists in a futures contract.
The seller of an options contract is called the ‘options writer’. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer.
There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed. When you are trading in the derivatives segment, you will come across many terms that may seem alien. Here are some Options-related jargons you should know about.
Premium: The upfront payment made by the buyer to the seller to enjoy the privileges of an option contract.
Strike Price / Exercise Price: The pre-decided price at which the asset can be bought or sold.
Strike Price Intervals: These are the different strike prices at which an options contract can be traded. These are determined by the exchange on which the assets are traded.