Options Contract Explained and Simplified

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There are many kinds of derivatives in the market. And among the most popular ones are options contracts. Just like many derivatives, their price is derived from an underlying asset.

Options trading written on a graph


An option is a contract involving two parties where there’s a buyer (holder) who buys the right (but not obligation) to buy or sell units of an underlying asset at a predetermined price from/to the options seller (writer) within a fixed period of time.

How do we simplify that definition?

Well, in simple words, options are a financial instrument for people who don’t like investing heavily on a particular security.  In its most basic form, it’s an agreement between two parties to sell or buy the right to an underlying asset.

When you use options, you can practice various strategies with different risk levels and profit potentials, paving the way for hedging and speculative trading opportunities for yourself.

Difference of Options and Stocks

In order to further illustrate what options are, let’s compare them to other asset classes. Let’s use stocks for comparison.

Unlike stocks, options have an expiration date, which can last for weeks, months, or years, depending on the regulations and type of option contract you have.  After the expiration date, the contract is basically useless.

You can gain some profits from a drop in the price of the underlying asset.  To go further, you can profit from any direction the market is taking, again depending upon the position or strategy you are holding. Though this is also possible in the stock market, it’s quite tricky and not every stock can be shorted.

Types of Options

There are really only two types of options.  They are the call options and put options, and all the others are just a combination of these two and strategies.

 A call option is a contract to buy an underlying stock on the or before its expiration date.  At the time of purchase, you can pay an amount of premium to the seller.  This premium grants you the right but not the obligation to buy the underlying asset at a predetermined price.

Meanwhile, a put option is a contract to sell an underlying stock on or before its expiration date. buying a put option means you are not so bullish about the market and you’re looking to find the price of the underlying asset going down. 


Strike Price

The strike price refers to the price at which the underlying asset can be bought or sold as per the contract.

The strike price for a call option tells the price at which the stock can be bought on or before its expiration. For put options,  the strike price refers to the price at which the seller can sell the underlying asset on or before the contract’s expiration.

Conclusion

Options are appealing financial instruments for traders because of the higher returns and fewer risks it gives.  However, it should be noted that it also carries unique disadvantages of its own, and they should not be ignored or downplayed in any way. 

You can also compare it with other kinds of derivatives like futures or CFDs. And while you’re at it, why not check other alternativeinvestments? A combination of these can diversify your portfolio in many ways.

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