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The Indian financial market comprises many assets, including equities, bonds, commodities, etc. However, derivatives are one of the most common asset types used by investors.
One kind of derivative is the options that grants the buyer the right but does not impose any obligation to sell an underlying asset at a later date and fixed price.
Financial instruments known as options allow you to purchase a valuable underlying asset at a relatively lower cost, which could result in significant gains. In this article, we’ll go into the basics of options, their features, and how they work.
Understanding derivatives and their types
Derivatives are financial contracts whose value relies on an underlying asset or a collection of underlying assets. The main idea behind derivative contracts is to make money by speculating how much the underlying asset will be worth. Derivative contracts come in four major types: swaps, forwards, options, and futures.
What are options?
As a derivative, the value of an option is based on the value of the underlying instrument. A stock, currency, index, commodity, or other kind of asset might be this specific underlying instrument.
Options give the buyer the right to trade an underlying asset at a fixed price at a later date. However, there is no obligation. Call and put options are the two categories of option contracts.
On the National Stock Exchange (NSE), the option stock list comprises 185 stocks, including some big names like Reliance Industries, Infosys, Tata Consultancy Services, HDFC Bank, etc.
Features of an options contract
Derivatives: Since the value of an option contract is based on how well the underlying asset performs in the market, option contracts are considered derivatives.
Expiration: Options are time-limited contracts. It will expire useless if the bearer doesn’t exercise the option by a specific date.
Strike price: A predetermined fee, known as the strike price, is attached to options; it is the amount at which the contract will be exchanged.
Speculation: Speculation is a strategy-based options trading. Instead of directly purchasing stocks, speculators use an options contract to establish a leveraged position at a lower cost.
Hedging: Investors use options to hedge their holdings by taking a contrary position in the market and lowering the risk associated with other open bets.
Zero obligation: The buyer of an options contract is free to execute the contract, but they have no obligation to do so. This implies that the option buyer may keep the contract and wait for the desired price movement rather than be forced to pay for or purchase the underlying asset.
Settlement: The option contract is considered settled when the option buyer chooses to exercise the right to purchase or sell the underlying assets on the expiration date.
Contract Size: Every option contract has a contract size, also known as a lot size, representing the amount of the underlying asset associated with the contract.
How do options work?
If you want to buy or sell an underlying asset at a specific future date, you may do so via an options contract on the stock market. Every options contract has an underlying asset that affects the contract’s pricing.
The underlying assets may be any securities, such as stocks, bonds, or commodities, where the investor has the right to purchase or sell them for a certain quantity at a predetermined price. However, investors are not obliged to execute the options contract and are free to exit if they believe the underlying asset’s price direction would result in a loss.
The following are some fundamental concepts related to stock market options:
Strike price: Alternatively referred to as the exercise price, this is the sum at which the sellers and purchasers decide to carry out the options contract at a later date.
Expiration date: The future date on which buyers of options contracts may exercise their right to purchase or sell the underlying asset is known as the options contract’s expiry date.
Premium: The amount that purchasers of an options contract have to pay sellers to have the right to execute the contract on or before its expiration date is known as the premium. It is the price paid to the seller for the risk he undertakes if, in any case, the asset price continues to shift adversely.
Spot price: In the stock market, this is the underlying asset’s market price at present. Buyers will examine this pricing to determine how much they may benefit or lose, based on which they decide whether to exercise or cancel options contracts.
Conclusion
One of the most profitable trading instruments is options, which may provide some of the highest returns on your original investment in the stock market. Today, the trading volume in the futures and options market exceeds 400 times that of the underlying cash-market turnover.
But before you start trading these securities, don’t forget to familiarise yourself with the risks involved.
FAQs
It depends on your goals, risk tolerance, and trading style. Options and stocks are different types of investments that have their own advantages and disadvantages. Options offer more flexibility and leverage, but also more risk and complexity. Stocks are simpler and more stable, but also more expensive.
Intraday and options are different trading strategies that suit different traders. Intraday trading involves buying and selling stocks within the same day, while options trading involves buying and selling contracts that give the right to buy or sell stocks at a later date.
Options trading is not gambling if you have a clear and rational strategy, understand the risks and rewards, and trade with discipline. Options trading can be gambling if you trade impulsively, emotionally, or without a plan. The difference lies in your attitude and approach.
Yes, with the correct mindset and trading tactics, options trading has the potential to provide substantial profits. Remember, option trading is not a guaranteed way to make money and requires careful planning and execution.
Yes, it is possible to earn daily from options trading, but it is not easy or risk-free. Options provide a leveraged return on an underlying asset, like stocks. However, options trading requires a lot of knowledge, skill, discipline, and capital.