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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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Great information .Really i get important information from your site.thank you for share informative blog.
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