An ‘option’ is a type of derivative contract that ‘derives’ its value from an underlying security (index, stock, etc). For investors who wish to lock in on an investment and observe its market performance before making a final decision - options trading is the right choice.
In options, the trader has the choice to buy or sell the equity any time during the duration of the contract i.e he/she has the right but not the obligation to buy or sell the security. The individual has the alternative to opt-out, and the loss is limited to only losing the premium paid at the time of signing the contract.
There are two types of options contract:
Call options agreement gives an individual the right to buy the underlying security at the given ‘strike price’ if he/she desires to, within the period of the agreement. The investor profits from bullish market tendencies i.e. when the market price of the security rises above the strike price since he/she purchases the security (In-the-money option) at the strike price and sells it at the market price (upside price action).
However, if the market price remains the same or falls, the options agreement is not profitable for the signee and he/she may choose to not exercise his/her right to purchase the security (At-the-money option).
Call options agreement gives an individual the right to sell the underlying security at the given ‘strike price’ if he/she desires to, within the period of the agreement. Unlike call options, the investor profits from bearish market tendencies i.e. when the market price of the security falls below the strike price. On the other hand, put options lose value when the price of the underlying security rises (downside price action).
Options advantages and drawbacks
Options trading has a lot of benefits like the right to buy a security without any obligation, less potential losses, added income, portfolio diversification, etc. But these contracts have certain risks as well.
The most imminent risk for an investor is to lose the premium he/she paid while signing the contract if the market price of the security doesn't go in the desired direction.
In addition to this, if one has subscribed to a brokerage firm to carry trades, he/she may also lose the fees paid to the firm if the investment doesn’t turn out to be profitable. Options also have the tendency to lose value as the agreement nears expiration due to the measure of time-value decay.
Options are a kind of derivative financial security that derive their value from an asset. They are of two types - put and call options. They have a certain risk associated with them but are suitable for individuals who would like to observe the market performance of their investment before allocating funds.