Options Contracts Explained: Types, Uses, Pros, and Cons

Most beginners in the investment sector start with stock trading. It is because many of them do not know about derivatives, commodities, currencies, and other financial instruments. Derivatives are financial contracts that can help investors speculate on future price movements of underlying securities. Experienced investors often prefer options (a type of derivative) due to added flexibility. Continue reading to understand how options contracts work and much more!

What is an Options Contract?

An options contract is a type of derivative or financial contract. It is a contract between two parties for the transfer of the underlying asset at a predetermined price, called the strike price. It allows the investor to buy/sell the underlying asset at a strike price on a future date. The future date for such contracts is referred to as the expiration date.

Futures contracts also allow the investor to buy/sell the underlying asset at a strike price on the expiration date. However, futures are still different from options. An options holder is not obligated to exercise the contract on the expiration date. You can ignore these contracts on the expiration date when the market prices are not in favour. This added flexibility cannot be observed in futures contracts.

Types of Options Contracts

Now that you understand what is an options contract, let us discuss its types:

• Call Option

  : A call option gives the holder/investor the right to buy the underlying asset at a strike price on the expiration date. Investors exercise call options when the spot price (market price on the expiration date) is more than the strike price. However, a call option will become worthless when the spot price is lower than the strike price.

• Put Option

  : A put option gives the holder/investors the right to sell the underlying asset at the strike price on the expiration date. Investors exercise put options when the spot price is less than the strike price. However, a put option will become worthless when the spot price is higher than the strike price.

• Chooser Option

  : Chooser options are available in a few markets. A chooser option can be changed into a call or a put before the expiration date. However, the expiration date and the strike price remain the same regardless of the choice. The premium (cost of the contract) for chooser options is high due to the added flexibility feature.

Besides the aforementioned types, option contracts can be divided into two more types based on the expiration date. The first type is the European-style option. A European option can only be exercised on the expiration date. The investor can also choose to ignore the contract on the expiration date. The second type is an American-style option. You can exercise an American-style option any time before the expiration date. It offers more flexibility to the investor, as they can take advantage of price movements throughout the tenure of the contract. Similar to any contract, you can ignore an American-style option when the prices are not in favour.

Examples

Now that you know the types of options contracts , let us look at an example. Beginners or new investors are often confused about how options work. 

For instance, a call option is based on stocks of a company named ‘ABC’. You invest in the call option and agree to buy ten stocks of ABC six months from now for Rs. 100 per share. It is crucial to note that we are discussing a European-style option in this example.

Six months from now, the market price of ABC stocks on the expiration date is Rs. 120. As per the contract, you can buy shares for Rs. 100, which is lower than the current market price. You will exercise the contract and earn a profit of Rs. 20 per share. It means that the total profit will be Rs. 200 (20 * 10). You would not have exercised the contract when the market price stayed below Rs. 100.

Rs. 200 will not be your total profit on exercising the contract. You still have to deduct the premium paid to acquire the call option from the seller. Let us say the cost of acquiring the call option was Rs. 60. In this case, your total profit will be Rs. 140 (200 – 60).

Features

Before you implement  options trading strategies , it is essential to know these features:

• The buyer or holder of such a contract will have the right to exercise or ignore the contract on the expiration date.

• Investors can sell or write it off to potential buyers. You will receive a premium upon selling an options contract.

• The strike price is predetermined. One cannot change the strike price in between the tenure of the contract.

• An options contract becomes worthless after the expiration date. When investors choose to ignore options due to unfavourable market prices, they become worthless.

• These contracts can be based on numerous securities. An option contract can be based on a stock, market index, currency, or any other asset.

Uses

Beginners in the stock market are often confused about call options vs put options. However, we have discussed the difference between the two, along with an additional type of option, the chooser option. Let us now discuss the uses of options contracts, which are as follows:

• They can help investors indulge in price speculation. Investors often predict future price movements associated with an asset. They can also speculate and invest simultaneously with the help of options.

• Many investors rely on such contracts for hedging against inflation. Options can help investors buy securities at a lower price amidst the rising inflation. Even if the market prices go up, you can buy an asset at a lower price with the help of a call option.

• Investors also rely on options for cash settlement in quick succession. Consider options contracts based on commodities. In this case, investors do not have to deliver or buy the actual commodities, as the contract can be settled in cash.

Advantages

Here are the pros of options contracts you must know:

• Options can offer insurance against rising prices or inflation. You can agree to purchase or sell an asset at a strike price on a future date with options. You can buy/sell the asset at a better rate even when market rates are not in your favour.

• Investors only have to pay the option premium to acquire an options contract. It means they can decide on buying the underlying asset later on the expiration date. Options require low trading capital, as compared to other investments.

• The loss is limited to the premium paid to acquire the options contract. On the other hand, the gains are unlimited with options trading.

Disadvantages

Here are some cons of options contracts you must know:

• Options buyers must know that the time value of a contract will decline as the expiration date approaches.

• Options trading might be complicated for beginners in the stock market. However, it isn’t so hard once you understand the basics of derivatives trading.

• The liquidity of options might be low in some markets, thus making it difficult to find buyers and sellers. For instance, the liquidity of chooser options is less in most markets.

• These contracts might not be available for all assets in a market. For instance, you might not find options based on stocks of new or lesser-known companies.

Option Contract Vs Firm Offer

You might have come across the term ‘firm offer’. Some of you might think options are the same as firm offers. However, there are several differences between an options contract and a firm offer, such as: 

Conclusion

Options contracts can help investors hedge their portfolios against rising prices. Also, one can indulge in price speculation and earn returns with options. Beginners in the stock market must be familiar with call, put, and chooser options. They can diversify their portfolios by investing in derivatives. It is crucial to not confuse options with futures, firm offers, or other contracts. Learn more about options trading today!