An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options are a type of derivative product.
The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option’.
Though they have their advantages, trading in options is more complex than trading in regular shares. It calls for a good understanding of trading and investment practices as well as constant monitoring of market fluctuations to protect against losses.
Just as futures contracts minimize risks for buyers by setting a pre-determined future price for an underlying asset, options contracts do the same however, without the obligation to buy that exists in a futures contract.
The seller of an options contract is called the ‘options writer’. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer.
There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed.
When you are trading in the derivatives segment, you will come across many terms that may seem alien. Here are some Options-related jargons you should know about
A future date on or before which the options contract can be executed. Options contracts have three different durations you can pick from:
*Please note that long terms options are available for Nifty index. Futures & Options contracts typically expire on the last Thursday of the respective months, post which they are considered void.
AMERICAN AND EUROPEAN OPTIONS:
The terms ‘American’ and ‘European’ refer to the type of underlying asset in an options contract and when it can be executed. American options’ are Options that can be executed at any time on or before their expiration date. ‘European options’ are Options that can only be executed on the expiration date.
PLEASE NOTE THAT IN INDIAN MARKET ONLY EUROPEAN TYPE OF OPTIONS ARE AVAILABLE FOR TRADING.
Lot size refers to a fixed number of units of the underlying asset that form part of a single F&O contract. The standard lot size is different for each stock and is decided by the exchange on which the stock is traded.
E.g. options contracts for Reliance Industries have a lot size of 250 shares per contract.
Open Interest refers to the total number of outstanding positions on a particular options contract across all participants in the market at any given point of time. Open Interest becomes nil past the expiration date for a particular contract.
Let us understand with an example:
If trader A buys 100 Nifty options from trader B where, both traders A and B are entering the market for the first time, the open interest would be 100 futures or two contract.
The next day, Trader A sells her contract to Trader C. This does not change the open interest, as a reduction in A’s open position is offset by an increase in C’s open position for this particular asset. Now, if trader A buys 100 more Nifty Futures from another trader D, the open interest in the Nifty Futures contract would become 200 futures or 4contracts.
As described earlier, options are of two types, the ‘Call Option’ and the ‘Put Option’.
The ‘Call Option’ gives the holder of the option the right to buy a particular asset at the strike price on or before the expiration date in return for a premium paid upfront to the seller. Call options usually become more valuable as the value of the underlying asset increases. Call options are abbreviated as ‘C’ in online quotes.
The Put Option gives the holder the right to sell a particular asset at the strike price anytime on or before the expiration date in return for a premium paid up front. Since you can sell a stock at any given point of time, if the spot price of a stock falls during the contract period, the holder is protected from this fall in price by the strike price that is pre-set. This explains why put options become more valuable when the price of the underlying stock falls.
Similarly, if the price of the stock rises during the contract period, the seller only loses the premium amount and does not suffer a loss of the entire price of the asset. Put options are abbreviated as ‘P’ in online quotes.