What Is an Option Contract?

If you are familiar with the idea of stock trading and have been involved in it for some time, you have probably heard of options trading, which is a type of derivative trading. Options are available for various assets and offer a wide array of features.

In this blog, we’ll discuss everything you need to know about different types of option contracts, their features and the associated risks. 

What is an Option Contract?

An option contract is a type of derivative instrument that gets its value from an underlying asset such as stocks, currencies, indexes, commodities, etc. The buyer of the option contract is granted a right, but not an obligation, to purchase or sell the underlying asset by a certain date at a certain price. Options trading can be profitable, but only if you strictly enforce a stop-loss to safeguard your investment from losses. 

Types of Option Contracts

There are several types of option contracts:

1. Based on the Right to Buy or Sell

There are two types of option contracts based on the right they provide to the buyer:

• Call Option: The buyer of the call option will have the right, but not the obligation, to purchase the underlying asset at a specified price within a specific period. Suppose the buyer believes that the underlying asset’s value will increase. In that case, they will purchase these contracts and pay the call option seller a premium that varies according to the underlying asset’s value. These contracts have an expiration date. A long-call strategy is to purchase a call option; a short-call strategy is to sell a call option. 
• Put Option: The buyer of the put option will have the right, but not an obligation, to sell the underlying asset at a specified price within a specific timeframe. Consequently, purchasing a put option entails creating a short position in the underlying asset and anticipating a price decline. Similar to call options, these contracts contain expiration dates as well. Purchasing a put is also known as a long put strategy, whilst selling an option is known as a short put strategy.

2. Based on Their Rules of Exercise

There are three types of option contracts based on the different exercise options they offer:  

• American Option: An American option contract is one in which the contract owner may exercise their right to purchase an asset, in the case of a call option, or sell it, in the case of a put option, at any time before or on the contract’s expiration date. The name does not imply that these contracts are exclusively available in the United States. It makes it possible for investors to profit quickly from market movement. An American call option is also denoted as CA, and an American put option is denoted using PA. 
• European Option: Unlike American options, this type of option permits an investor to exercise their right to purchase, in the case of a call option, or sell, in the case of a put option, an underlying asset at a certain strike price only on the expiration day. Options available in Indian financial markets are European and referred to as CE for call and PE for put.
• Bermudan Option: These are a special type of American option as they also allow for early contract exercise, but only on specific dates. These dates are mentioned in the option contract.

3. Based on the Underlying Asset

• Index Option: An index, as opposed to a single stock, serves as the underlying asset for an index option contract. An investor can profit from market index movement when they trade in index options, and because an index contains a variety of individual stocks, diversification helps to reduce risk. These kinds of contracts are usually settled in cash. 
• Stock Option: A stock option enables an investor to purchase or sell a particular stock at a predetermined price, known as the strike price, within a specific timeframe. One can insure their portfolio against market volatility by using stock options. With call and put options, you can use your assumptions to go long or short on the stock. 
• Commodity Option: The underlying asset in this option contract is a commodity like gold, silver, etc. The value of these option contracts changes in line with changes in the commodity’s underlying price.  

Features of an Option Contract

Features of an option contract are listed below:

1. The option contract differs from buying any asset, as it derives its value from an underlying asset.
2. Option contracts give the buyer a right but not the obligation to exercise a contract.
3. There is a predetermined price, also known as the strike price, at which you can exercise the option contract.
4. There are fixed dates on which one can exercise a contract.
5. The option contract comes with a fixed contract size, known as lot size. You can buy or sell the contract in multiples of the market lot.

Uses of Option Contracts

Option contracts can be used for the following purposes:

1. Hedging: It is a risk management technique that allows one to protect their portfolio from losses. 
2. Income Generation: An investor can receive the premium and make a consistent income by selling option contracts on their equities. 
3. Speculation: Traders use option contracts to generate profit from their view of the market movements. They buy calls or sell puts if they expect the underlying asset’s price to increase and buy puts and sell calls if they expect the underlying asset’s price to decrease.

Advantages of Option Contracts

The advantages of an option contract are:

1. Because you can obtain the underlying asset for a small portion of its total value, the option provides leverage, which can magnify investor’s returns. 
2. Options can be used as hedging instruments in your portfolio to safeguard it from market downturns. 
3. Selling options can help generate a regular income by receiving the premiums.

Disadvantages of Option Contracts

The disadvantages of an option contract are:

1. The option market is considered risky due to various factors affecting its value simultaneously, such as the time value of money, volatility, etc., making it extremely complex to understand. 
2. Option contracts provide leverage, which magnifies losses and can result in a complete loss of capital.
3. Option contracts for some assets may have lower liquidity due to the non-availability of buyers and sellers, as most people do not trade in options.
4. Trading in an option contract requires margin as you are required to pay a certain sum of money to your broker to cover the potential losses, and selling an option contract requires even higher margins than buying an option contract.

Conclusion

Only those who thoroughly understand market dynamics and techniques and are well-versed in option trading concepts can consider it a good investment alternative. Trading in options can offer you the chance to make larger profits with fewer initial investments. Traders must always be careful as these instruments are extremely risky and can result in huge losses. Therefore, you must speak with your investment advisor before making trading decisions. 

Frequently Asked Questions (FAQs)