Last Updated: Thursday, October 20, 2016

UNDERSTANDING OPTIONS CONTRACTS: A simplified Approach

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An "Option" is a type of security that can be bought or sold at a fixed price within a specified period of time, in exchange for an initial deposit and nonrefundable. An option contract gives the buyer the right to buy, and not the obligation to buy at the price or the date specified. Options are a type of derivative. 

What are OPTIONS CONTRACTS?
In Simple words, an option is a contract that gives the buyer the right but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date. Therefore, an option, as a stock or bond is a security and also a contract with terms and strictly defined properties.


 WHY OPTIONS ARE USED?
They can be used as:
Leverage: Options to help you take advantage of changes in equity without depositing the full price of the share. You get control over the actions without buying outright.
Hedging: They can also be used to protect against fluctuations in the price of a stock and let you buy or sell shares at a predetermined price during a specified period of time.
             Although they have their advantages, options trading is more complex than the trading of the common shares. It calls for a good understanding of trading and investment practices and constant monitoring of market fluctuations to protect against losses.

UNDERSTANDING STOCK OPTIONS TRADING IN SIMPLE WAY
The idea behind an option is present in many everyday situations. For example, you discover a house you want to buy. Unfortunately, you do not have enough money to buy it for three months. You talk to the owner and bargain an agreement that gives you the opportunity to buy the house in three months for Rs. 200,000. The owner agrees to your proposal, but for this option, you require to pay a price of 4,000.
Now consider two theoretical situations that might occur:
1. Owner discovered that the house is actually the true birthplace of an eminent personality! As a result, the market value of the house shoots up to one million. Because the owner sold you the option, he has to sell the house for the agreed amount only i.e. Rs. 200,000. In the end, you stand to make a profit of Rs. 796 000 (1 million - Rs. 200,000 - Rs.4,000).
2.  By visiting the house, you discover not only that the walls are chock full of asbestos, but ghosts haunt the bedroom; Although you initially thought you had found the home of your dreams, you now consider it useless. On the positive side, because you purchased an option, there is no need to go through the sale. Of course, you always lose the price of Rs. 4,000 per option.
This example illustrates two important points here; first, when you buy an option, you have the right but not the obligation to do something. You can always let the expiration date go, how the option becomes worthless. If this happens, you lose 100% of your investment, which is money you used to pay for the option. Secondly, one option is simply a contract that covers an underlying. For this reason, options are called derivatives, which mean an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or index.

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WHAT ARE CALLS AND PUTS?
Calls and Puts:
The right to sell a stock is called "Put Option", While the right to buy is called 'Call Option'.
A call gives the holder the right to buy an asset at a certain price within a specific time period. Calls are similar to having a long position in a stock. The Call buyers hope that the stock will increase substantially before the expiration of the option.
A put gives the holder the right to sell an asset at a certain price within a specific time period. Puts are very similar to having a short position on a stock. Buyers of puts hope that the share price will fall before the option expires.
MARKET PARTICIPANTS IN OPTIONS TRADING

There are four types of market participants in options trading depending on the position they take:
*                 Call buyers
*                 Sellers of calls
*                 Buyers of puts
*                 Sellers of puts
People buying options are called holders and People buying selling options are called writers; In addition, buyers are said to have LONG positions, and sellers are said to have SHORT positions.
Distinction between buyers and sellers:
Call holders and put holders (buyers) are not obliged to buy or sell. They have the choice to exercise their rights if they choose.
Call writers and put writers (sellers), however, are forced to buy or sell. This means that the seller may be required to make good on a promise to buy or sell.

Do not worry if this sounds confusing - it is. For this reason, we will examine the options from the perspective of the buyer. Put options is more complicated and can be even more risky. At this point, just understand that there are two sides of an options contract.

HOW OPTION CONTRACTS ARE PRICED?
 We have seen that the options can be purchased for an underlying asset at a fraction of the actual price of the goods in the spot market, paying a premium in advance. The amount paid as a premium to the seller is the price to enter into an option agreement.
To understand how this premium amount is arrived at, we first need to understand some basic terms as in-the-money, out-of-the-money and at-the-money.
We take a look, as you can be in front of one of these scenarios, while the trading of options:
*     In-the-money option: You profit by exercising the option.
*     Out-of-the-money option: You will not make money by exercising the option.
*     At-the-money option: A non-profit scenario, no-loss if you choose to exercise the option.
A call option is 'in-the-money', when the spot price of the asset exceeds the strike price. Conversely, a put option is 'in-the-money', when the spot price of the asset is below the strike price.
you should also watch this youtube video uploaded by ICICIdirect;
How to do an options trading in India.

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