Know Types & Features of Options: How do they work?
Just like other Derivatives, Options have a long history. Options can be traced back to Ancient Greece, where they used them for harvest speculations. More recently, in the 1920s, Options are associated with the American trader Jessie Livermore and the illegal firms known as ‘Bucket Shops’. While such illegal activity is still associated with Options, they have become more popular among legal traders and are now widely used by investors and traders.
What are Options?
Options are a type of derivatives contract wherein two parties form an agreement that provides the buyer with the right to buy or sell underlying assets at a predetermined price within a specific period. However, the buyer is not legally required to fulfil the terms of the contract. Options present a wide range of variables as they are available on a wide range of underlying assets.
Additional read: How to Manage Risk While Trading in Derivatives
How do Options work?
- The working of Options is dependent upon the calculation of the future price of an underlying asset.
- Options lose value over time.
- Options based on volatile underlying assets present significant arbitrage opportunities.
- Options work as insurance when you buy both the Call and Put Options of an underlying asset.
Types of Options
Based on the right they provide the holder; Options can be classified into two categories:
- Call Options entitles the holder to purchase an underlying asset for a fixed price at a predetermined date, but the holder is not legally obligated to do so.
- Put Options entitles the holder to sell an underlying asset for a fixed price at a predetermined date, but they are not legally required to do so.
Based on how they can be exercised, Options can be classified into two categories:
- European Options can only be exercised on the date of expiration. Thus, investors cannot take advantage of higher prices or protect themselves from lower prices of the asset in the duration of the contract. Put and Call parity applies to European Options.
- American Options can be exercised at any point in the duration of the contract, including the expiration date. That allows investors to reap profits from higher prices.
Based on the relationship between the contract and the underlying asset, Options can be classified into three categories:
- When Options have higher strike prices than their underlying assets, they are called Out of Money (OTM) Options.
- If the market price of underlying assets is above the strike price, they are called In the Money (ITM) options.
- When the strike prices of Options are equivalent to the market price of underlying assets, they are called At the Money (ATM) Options.
Features of Options
Options have the following features:
- Premium refers to the price paid by the holder to acquire the right to buy or sell an underlying asset. The holder receives their payoff upon exercise of the contract after the premium is deducted.
- Strike Price refers to the price at which the holder can exercise their Options. The Strike Price is fixed for the duration of the contract.
- The expiration date of Options is fixed and cannot be changed. Options have limited terms and lose value over time.
- Contract Size refers to the size of the underlying asset which the holder gains the right to purchase or sell. Contract Size is fixed on every contract.
- Holders of Options are not legally bound to fulfil the terms of the contract. That sets Options apart from other classes of Derivatives.
Options provide unique opportunities to investors and can be an introduction to more complex segments of financial markets. Thus, they play a pivotal role in the growth of trade in Derivatives. However, the risk associated with any derivative instrument is relatively high compared to any other financial device. Therefore, it is best advised to have an in-depth understanding of options trading before entering into any such contract. Knowing the pros and cons of options trading might help the investor make an informed decision regarding the transaction.
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