Options Contracts (Options Contracts) are contracts that give the holder the right, but not the obligation, to buy (call options) or sell (put options) a specific underlying asset on a fixed date and at a specified price, called the strike price or redemption price. Today we will look at this lesser-known financial instrument. So – let’s get to it!
Option contracts – definition
Option contracts are a type of financial instrument that allows a trader to buy or sell an asset at a fixed price before or on a specified date. Unlike futures contracts, option contract traders are not obliged to execute trades. Options are flexible and give traders the right, but not the obligation, to make a transaction in accordance with set terms.
These instruments, commonly referred to as “options,” are a type of derivative, the value of which depends on the value of an underlying asset, such as stocks, commodities, currencies or indices. Option contracts can be used both to hedge against risk and to speculate on the financial market.
How do Option Contracts work?
There are two main types of options: call options (calls) and put options (puts). Call options allow owners to buy the underlying asset at a predetermined price, while put options give them the right to sell the asset. The decision to choose options depends on forecasts of future price movements in the market.
Option contracts consist of several key elements, such as size, expiration date, strike price and premium. Size refers to the number of contracts a trader wants to enter into. The expiration date is the date after which traders can no longer exercise the option. The strike price is the price at which the underlying asset will be bought or sold, and the premium is the fee for buying the option.
The value of an option depends on the ratio of the strike price to the current market price of the underlying asset. Investors may decide to exercise an option if the strike price is more favourable than the current market price, allowing them to make a profit. In contrast, if the strike price is less favourable, the option holder has no incentive to exercise the option and the contract loses value.
Types of Option Contracts
Options can be classified based on the style of exercise:
American options: Can be exercised at any time before the expiration date.
European options: Can only be exercised on the expiration date.
Options can also be classified as standard (listed on an exchange) or custom (constructed to order).
Application of Option Contracts
Option contracts are mainly used in hedging, that is, hedging against risk. For example, an investor who owns a stock may buy a put option to hedge against a decline in its value.
Options are also popular in speculative trading. Investors can buy call options, expecting asset prices to rise, or put options, anticipating a decline. “In-the-money” options are profitable when the strike price is more favourable than the market price. “Out-of-the-money” options are not profitable, and ‘at-the-money’ options are at the threshold of profitability.
Benefits and drawbacks of Option Contracts
Benefits:
Hedging: Protection against market risk.
Flexibility: Allow for a variety of trading strategies.
Speculation: Ability to profit from fluctuations in asset prices without owning them.
Disadvantages:
Complexity: Require understanding of complex mechanisms and calculations.
Higher risk: Especially for option writers.
Low liquidity: Options markets can be less liquid than other financial markets.
Premiums: Vulnerable to significant fluctuations and decreasing as time passes until contract expiration.
Summary
Option contracts are an important financial instrument that allows investors to both hedge portfolios against price risk and speculate in the market. Their flexibility and diversity make them an attractive tool for investors with different levels of experience. However, before deciding to invest in options, it is important to understand how they work and the risks involved.
