Options contracts are a type of financial derivative that allows you to make a high profit with a very low initial investment. These financial instruments derive their value from an underlying asset, which can be stocks, currency, indices, commodities, or other securities. The nature of options contracts is that they give the buyer the right (but not the obligation) to execute a transaction at a predefined price on a specified date. In this article of FFMAG, we intend to introduce options contracts.
What are options contracts?
Options contracts are financial tools that allow you as an investor to purchase a high-value underlying asset at a relatively low price. As a result, you have the potential to make significant profits. Options contracts derive their value from a different underlying asset, which is why they are also referred to as derivative instruments. Depending on the type of option you have, these contracts offer you the choice to buy or sell the asset.
Advantages and disadvantages of options contracts
Given that options contracts are a very unique investment tool, it is important to learn their unique features before deciding to use them. The advantages and disadvantages of transaction contracts are listed in the table below:
Terms used in options contracts
As mentioned, while options contracts can be very profitable for you as an investor, you must have a full understanding of their complexities. Some of the terms used are:
- Strike Price: This is a predetermined price at which you can proceed to buy (for a call option) or sell (for a put option) the underlying asset. Essentially, the strike price is a fixed reference point for determining potential profit or loss.
- Expiry Date: Every options contract has a specific expiration date, after which the contract becomes void.
- Contract Size: This refers to the amount of the underlying asset that you are going to trade. For example, an options contract might cover 100 shares as the underlying stock.
- Options Premium: Options contracts include a payment option known as the options premium. The contract holder will have the right to carry out the required trading activities by having this option. If the holder decides not to use their right, the options premium is forfeited.
- Intrinsic Value and Time Value: The price of an options contract consists of two main parts, which are the intrinsic value and the time value. The intrinsic value is the difference between the current market price of the underlying asset and the strike price. The time value is the options premium that is above the intrinsic value and considers factors such as the remaining time until expiration and market volatility.
- Hedging: Options contracts serve multiple purposes and can also be used for hedging. In this case, they act to protect against potential losses in the underlying asset.
Types of options contracts
So far, we have been introduced to the concept and general terms in options contracts. It is necessary to know that options contracts can only be in two forms, which are call options and put options. Next, we will describe these two contracts.
Call Options (Call Option)
A call option gives the holder the right (not the obligation) to buy the underlying asset at the predetermined price (strike price) before or on the expiration date. Call options are typically used when the investor expects the price of the underlying asset to increase. In other words, by purchasing a call option, the investor essentially “locks in” a price at which they can buy the asset regardless of the actual market price on the expiration date. If the market price is higher than the strike price, the call option holder can profit by buying the asset at a lower price. This type of contract is colloquially known as a “call option.”
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Example of call options
Imagine an investor closely follows the performance of ABC Electronics, and the current trading price of each share is $150. Our investor believes that due to an upcoming product release, the share price of this company will significantly increase in the coming months. To maximize the benefit from his forecast, he purchases a call option of ABC Electronics with a strike price of $160, setting the expiration date three months later.
Fortunately, the investor’s prediction turns out to be correct, and by the expiration date, the price of each share of the company increases to $180. Now, thanks to the call option contract, the investor can use his right to buy shares at the pre-agreed target price of $160, even though the market price is higher. This allows the investor to purchase the desired shares at a price less than the current market value, thereby potentially making a profit.
Put Options (Put Option)
A put option gives the holder the right (not the obligation) to sell the underlying asset at a predetermined price (strike price) before or on the expiration date. Put options are usually used when an investor predicts that the underlying asset will decrease in price. Obtaining a put option contract allows the investor to sell the asset at a price higher than the market price, thus staying protected from potential losses. This type of contract is colloquially known as a “put option.”
Example of Put Options
Consider an investor monitoring the performance of a pharmaceutical company named XYZ Pharma, currently trading each share at $200. Our investor is concerned about potential market fluctuations and believes that the stock price might decrease due to uncertainties. To protect against potential losses, he purchases a put option for XYZ Pharma with a target price of $190 and sets the expiration date six months later. As predicted, the stock price enters a downward trend, and by the expiration date, the value of each share drops to $170.
Now, by activating the put option contract, the investor can sell the shares at the target price of $190, even though the market price has decreased. This contract effectively provides coverage against losses that would have been incurred if the investor had sold the shares in the current market at $170 per share. In both cases, options contracts create a strategic advantage for investors, allowing them to benefit from their market predictions while also reducing potential risks.
How do options contracts work?
Options contracts serve as tools for investors to invest based on price movements while managing risk. Call options provide the possibility to buy at a specific price, while put options offer the possibility to sell at a predetermined price. These tools provide flexibility to profit from both upward and downward market trends and are typically used for risk hedging and generating income through options premiums.
Types of trading strategies for using options contracts
The nature of options contracts allows them to be used in various scenarios; although we have fully described the two main types. Other types of options trading strategies include:
- Bull call spread: An optimistic strategy where a trader buys a call option and sells another with a higher strike price. The trader is optimistic about the market and will profit when the price of the underlying asset increases.
- Bull put spread: The trader purchases a put option and sells another put with a higher strike price than the previous. The trader profits when the price of the underlying asset increases.
- Synthetic call or Protective put: The trader purchases the underlying asset and a put option on it. If the price increases, there is unlimited profit. If the price decreases, the loss is limited to the options premium paid for the put.
- Bear call spread: A bearish strategy where a trader purchases a call option and sells another put with a lower strike price than the first. Profit only occurs if the asset price decreases. Both profit and loss are limited.
- Bear put spread: When a trader expects the market to decline, they purchase a put option and sell another with a lower strike price than the first. In this scenario, both loss and profit are limited. Profit occurs when the asset price decreases.
- Synthetic put or protective call: The trader profits when the market declines. This strategy combines a future sell position with the purchase of a call option. During a price decrease, profit is unlimited and loss is limited to the options premium.
How to use options contracts?
Now that we are familiar with options contracts and their types, let’s see how they can be used. Generally, there are two ways to profit from options contracts:
- Holding the option until expiration: You can keep the options contract until the expiration day and profit if the market price is favorable as mentioned above.
- Trading options contracts: Even before the expiration date, you can sell your contract in the derivatives market. Doing so can be profitable when the contract’s market price has increased from the time of your purchase. For example, if you purchased the options contract at $12.05 but it later reaches $15, you can sell each share at $15 and the difference will also constitute your profit.
To profit from options trades, you must be able to predict market direction and then consider your options strategy accordingly. For example, if you expect the price of the underlying asset to increase, a long call or short put contract might be beneficial for you. Conversely, if you expect the price to decrease, a short call or long put might be a suitable option.
Use Options Contracts Wisely
Investors who trade using options contracts must evaluate the associated consequences based on their risk tolerance and investment style. While these contracts offer opportunities for profitability and risk reduction, they require a deep understanding of market dynamics and strategy implementation. It is advisable for beginners to undergo training and use a demo mode for practice initially, while also benefiting from professional guidance. In conclusion, making informed decisions is closely linked to the investor’s risk tolerance and long-term financial goals.
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