Option contracts are Types, concept and features

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Beginner traders have a particularly difficult time. After all, the stock market is replete with terms unfamiliar to them. You have to spend a lot of your own time and effort to understand everything and comprehend the theory of investment science. Let's find out what options contracts are. This is a term that experienced traders have repeatedly encountered. But for beginners, it may seem incomprehensible.

Concept

Option contracts are contracts under which one party acquires the right to buy an asset at a set price before a set date. This right for the seller turns into an obligation to buy or sell the asset at a predetermined price. It is worth noting that the buyer pays the option premium to the seller for this. Hence the similar name of the contracts. By the way, as an abbreviation, traders often call them simply options. This is important to know.

Views

Option contracts are contracts that come in several types. This information will also be useful for a novice trader.

1. If an option provides the right to purchase an asset, it is called a call.
2. If the contract provides the right to sell an asset, it is called a put.

Each option has a set expiration date, which is limited to its expiration date. Depending on this, Asian, European, and also American option contracts are distinguished. This needs to be explained.

Asian gives the right to conclude a transaction in the period between the agreed date and the expiration date of the option. European allows you to make a transaction related to the purchase or sale of an asset, but only on a certain day. The American one is the most loyal and provides the opportunity to use the right to buy absolutely any day before the expiration of the option contract. These terms are important to know before making a deal.

However, these are not all types of such contracts. They can also be standard or exotic. Standard (the second name is vanilla) are present on the exchanges and generally fit into the concept of options. Exotics are issued by financial institutions in accordance with customer requests. In this regard, the terms of such option contracts can be absolutely anything. That is why you need to work with them especially carefully, carefully studying all the listed conditions.

According to the form of implementation, option currency contracts are divided into two types.

1. With physical delivery. In this case, the ownerreceives a certain number of underlying assets.
2. Cash. In this case, the owner manages to get some difference, which is calculated between the price at the time of the conclusion of the option contract and at the time of its implementation.

Features of the option

Each type of contract has its own unique differences. Features of option contracts are that they can be used to insure against risks. In some ways, such contracts are like buying insurance policies. They also pay a premium, which is called an option. This fee provides the buyer with a guarantee that the price specified in the contract will be fixed for a certain period.

In any transaction there is an opposite side. When concluding an option contract, it is investors or speculators who take on certain risks and receive a reward for this. This feature also resembles the principle by which insurance companies operate. It is curious that if the development of events is unfavorable for an investor or a speculator, there is a possibility of making a reverse transaction.

It is important for a novice trader to understand that the financial responsibility of investors and speculators with whom the buyer enters into an option contract is potentially unlimited. Accordingly, in some situations, it may exceed the amount of funds that were originally invested.

Open positions on option contractsmean their total number free under warranty. You need to understand that every transaction requires the presence of both parties. It is both a seller and a buyer. The total number of open positions, which changes and is published daily, allows you to assess the trend towards their increase or, conversely, decrease.

Commodity options

Are types of option contracts. They are concluded exclusively on exchanges, they are fully standardized and can be closed with a reverse transaction. As a rule, they are short-term. On average, the period of validity of exchange options does not exceed one year. At the same time, the most common option is contracts with a validity period of three months.

OTC options

The market for these contracts is created by dealer banks, which simultaneously act as one of the parties to the transaction. They take on the role of clearinghouse with the difference that risk guarantees do not extend to the entire transaction market.

Specialists divide non-exchange option contracts into short-term and long-term ones. The latter, in turn, can be single-period or multi-period.

Option contract value

This indicator depends on several factors.

1. Time until the end of the contract. The value of the option is lower the closer the expiration date is.
2. Risk free interest rates.
3. Option style. As noted above, there are Asian, European, and American.
4. Individual evaluation of market participants.

Worth itIt should be noted that the value of option contracts is also influenced by some other factors. As a result, their totality determines the final cost at which the transaction is concluded.

Benefits of options

There are several reasons why traders often prefer this type of contract.

1. High profitability. The potential profit that can be received from the transaction under the terms of the option exceeds the premium paid by the buyer.
2. The minimum risk on the part of the buyer is the loss of the premium. At the same time, in exchange, he gets the opportunity to extract almost unlimited profits.
3. The ability to choose a strategy. The buyer has a fairly wide choice. For example, no one forbids him to combine different contracts, conduct operations in parallel on several option markets, etc.

Futures and options contracts

Both concepts, one way or another, are present in the stock market, so they should be familiar not only to experienced traders, but also to novice traders.

What are options, you already know. It's time to learn about futures.

This term refers to contracts of sale, the object of which is a certain amount of an asset. The peculiarity of the transaction is that it must take place on the agreed date at the price agreed upon by the parties at the time of signing the agreement.

There are two parties in a futures contract, namely the seller andbuyer. In accordance with the terms, the latter bears the obligation associated with the acquisition of the asset. The seller, on the contrary, bears the obligation to sell the object of the transaction. Accordingly, after the conclusion of the futures contract, both parties have mutual obligations.

It is worth noting that such a deal has some important feature. Until the period until the specified period has expired, both the seller and the buyer have the full right to cancel the obligations assumed. This is possible in two ways. In the first, after acquiring a futures contract, it can be sold. In the second, on the contrary, after the contract is sold, it can be purchased.

In general, futures trading is one of the varieties of the investment process, which allows traders to speculate in conditions of constantly changing quotes.

What assets can act as objects in futures contracts? We list the main ones:

• oil;
• gold;
• steel;
• wood;
• grain;
• currency, etc.

Every day, traders make an incredible number of futures transactions, the objects of which are the above goods. However, in most cases, these transactions are made for speculative purposes. This means that traders try to buy assets cheaper and later sell them at a higher price. It is extremely rare that the ultimate goal of purchasing futures is to receive or deliver the specified asset.

Differences

Let's find out how the above contracts differ from the options we talked about earlier.

The difference between both concepts is quite significant. A futures contract imposes an obligation on the buyer to purchase an asset. Option, on the contrary, only provides this right, the buyer is not obliged to buy it. He makes this transaction entirely voluntarily. However, the option contract imposes on the buyer an obligation to pay a premium to the potential seller, thanks to which the transaction becomes profitable for him.

Comparing options and futures, it would be incorrect to oppose one to the other. Both contracts can be used in parallel, thus obtaining the highest profit from your own investment activities. A novice trader should know about this.