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What Is Options

An option is a derivative contract that gives the owner the right to buy or sell an underlying asset at a specific strike price in the future, for which the buyer pays a premium. There are two main types of options: call options, which allow buying, and put options, which allow selling. The risks and potential profits vary between option buyers, who face limited risk and unlimited profit potential, and option sellers, who receive a premium but face unlimited risk.

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10 views10 pages

What Is Options

An option is a derivative contract that gives the owner the right to buy or sell an underlying asset at a specific strike price in the future, for which the buyer pays a premium. There are two main types of options: call options, which allow buying, and put options, which allow selling. The risks and potential profits vary between option buyers, who face limited risk and unlimited profit potential, and option sellers, who receive a premium but face unlimited risk.

Uploaded by

amitmehta29
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Understanding

OPTIONS
from basics
What is an Option?
An Option is a type of derivative contract that
derives its value from the underlying asset or
security. The underlying usually stocks.

An option contract gives its owner the right


but not the obligation to buy or sell an
underlying stock at a specific price
(Strike Price) in the future.

To get this right, the option buyer pays a small


premium to the option seller.
Types of Options Contract

Call Option:
The owner of the call option has the right to
buy the underlying at a specific strike price
for a specific time period.

Put Option:
The owner of the put option has the right to
sell the underlying at a specific strike price
for a specific time period.
Let's understand with Example:
Let's say you believe that the stock price of ITC
currently trading at ₹200 will increase soon.

You decided to buy the one-month call option


of ITC with a strike price of ₹205 by giving a
premium of ₹2 to the call seller/writer.

If ITC stock reaches ₹215 next month you can


exercise the option and buy the ITC stock at
the strike price of ₹205 only.
If the price doesn't increase or decrease in
the next month. You have a choice to not
exercise the option.

If you exercise the option when it reaches


₹215, your profit will be (215 - 205 -2 )= ₹8.
₹2 will be subtracted since it was already
paid as a premium.

If the price doesn’t increase you do not


exercise the option. The loss is limited to
the premium that you paid which is ₹2.

It works exactly the opposite for the put


option where you only exercise the option
when it reaches below the strike price.
Option Buyer
The option buyer pays a premium to the
option seller for the right to buy or sell the
underlying.

Buyer of an option has limited risk up to the


premium paid & can earn an unlimited profit.

The biggest risk for option buyers is time


decay and a drop in volatility.

Due to these risks, the option buyer loses


most of the time in the trade.
Option Seller/Writer
The option writer only receives a premium
and has an obligation to perform if the
buyer exercises the option.

The risk is unlimited for the seller and profit


is fixed to the value of the premium.

Although the risk is high, the option seller


has a high probability of success due to
factors like time decay and volatility.
Option Terminologies

Option Premium:
The option buyer pays a small amount as a
premium to the seller to get the right to buy
or sell the underlying. It is also called the
price of the option.

Strike Price:
It is the price at which the buyer buys the
underlying in the future if he decides to
exercise the option.
Expiry Date:
It is a date on which an options contract
expires and becomes invalid. It only expires
if it is not exercised.

Contract Size:
Contract size represents a specific number
of underlying shares that a trader may be
looking to buy.

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