What is an options contract? Features of options trading
What is an option contract? How do options trades work? What are their characteristics & options strategy?
Options are a popular type of derivative product in traditional finance and Crypto.
In today’s article, we will learn what an options contract is, how it works as well as some of its applications, advantages & disadvantages.
What is an option contract?
An Options Contract is an agreement in which an investor entering the contract has the right to buy or sell an asset at a predetermined price, which may occur before or at a certain time certain.
While the concept may sound like a futures contract, investors who buy options are not obligated to exercise their positions.
Options contracts are often used to hedge against potential risks in existing positions or used for price speculation.
There are two basic types of options, known as put and call options:
- Call Options give the contract holder the right to purchase future security at a predetermined price.
- Put options give the holder the right to sell a secured asset in the future at a predetermined price.
Therefore, investors often:
- Buy Call Options when predicting the price of the underlying asset will increase.
- Buy a put option when predicting the price of the underlying asset will fall.
In addition, investors also combine both types of contracts to their advantage based on predictions of market movements.
Components of an options contract
An options contract consists of at least four components: Size, expiration date, strike price, and option premium:
- The size of the order is related to the number of contracts traded.
- Expiry Date is the date after which the investor will no longer be able to exercise the option.
- Strike Price is the agreed price at which the asset will be bought or sold (in case the buyer of the contract decides to exercise the option).
- The premium is the purchase price of the option contract. It is the amount that the investor must pay to get the option. Thus, the buyer obtains the contract from the seller for the value of the option premium. This fee will fluctuate as the maturity date gets closer.
How options trading works
Basically, we will have 2 cases when we have bought an options contract:
- If the strike price < market price, the investor can buy the underlying asset at a cheap price, and after including the exercise premium, he or she can choose to exercise the contract for a profit.
- If the strike price > the market price, the investor has no reason to exercise the option and the contract is considered useless. When the contract is not exercised, the buyer only loses the option premium that they had to pay to buy the position.
It is important to note that although a buyer can choose to exercise or not exercise his or her call or put option, the seller must exercise his or her position if the buyer decides to exercise it.
So, if the buyer of a call option decides to exercise his or her contract, the seller is obligated to sell the underlying asset.
Likewise, if an investor buys a put option and decides to exercise it, the seller is obligated to buy the underlying asset from the person who bought the contract.
This means that the seller of the option bears a higher risk than the buyer.
While an option buyer’s losses are limited to the value of the premium they paid to buy the contract, the option seller could lose more depending on the market price. of property.
Some contracts allow an investor to exercise his or her option at any time prior to the expiration date. They often refer to contracts like these as American options. In contrast, European-style options contracts can only be exercised on the contract’s expiration date.
Features of options contract
- Investors can use option syndication to hedge market risk for existing positions.
- Options syndication allows investors more flexibility in speculating on the underlying asset’s price.
- Allows for multiple combinations and trading strategies, with distinct risk/reward mechanisms.
- Potential to profit from all market trends up, down or flat.
- The working mechanism and calculation of contract fees are not always easy to understand.
- There are many risks, especially for the seller.
- Trading strategies are more complex when compared to conventional alternatives.
- Options markets are often plagued by low levels of liquidity, making them less attractive to most traders.
- The value of the options premium is very volatile and tends to decrease as the contract’s expiration date approaches.
The difference between options and futures contracts
Both Options and Futures are popular derivatives in Traditional Finance & Crypto. Despite the similarities, there is a major difference in the liquidation mechanism of the two types of contracts.
Unlike an options contract, a futures contract is always exercised when the expiration date is reached, meaning that the policyholder is legally obligated to exchange the underlying asset (or its corresponding cash value). .
Meanwhile, an options contract is only subject to the decision of the holder of the contract. If the contract holder (buyer) exercises the option, the seller of the new contract is obligated to trade the underlying asset.
Basic options trading strategies
Options contracts are commonly used as hedging instruments.
Investors buy put options on the positions they hold. If the total value of the position they hold decreases due to the falling price, they can exercise a sell option to help reduce their loss.
Duy bought 100 ETH at $3,000 per ETH in the hope that the market price would rise. However, in order to hedge the risk of ETH price falling, Duy decided to buy a put option with a strike price of $2,500 per ETH and pay a $100 exercise fee per ETH.
If the market goes down and the price drops to $2,000 per ETH, Duy can exercise his options to reduce his loss and sell each ETH for $2,500 instead of $2,000. But if the market goes up, Duy doesn’t need to exercise the contract and will only lose the option exercise fee ($100 per ETH).
Options contracts can also be used for speculative trading. For example, if an investor believes that the price of an asset is about to rise, they can buy a call option.
- If the asset’s price rises above the strike price, then the investor can exercise the option and buy the asset cheaply.
- If the market doesn’t go the way the investor wants, he or she can waive the right to exercise the option and only lose a fee.
Thus, we have learned what options are, some applications, advantages & disadvantages of Options Contracts. If you have other questions related to the above topic, please comment below so that idolmeta.net can help you right away!