Types of Options Contracts

  • 31/01/2022

Types of Options Contracts: Understanding the Basics

As an investor, you have probably heard about options trading as a way to diversify your portfolio and potentially increase your returns. However, if you are new to options trading, it can be overwhelming to learn about the different types of options contracts available.

Fortunately, this article will explain the basics of options contracts and introduce you to the most common types of options.

What Are Options Contracts?

An options contract is a financial instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price and date. The underlying asset can be any tradable asset, such as stocks, indices, commodities, or currencies.

In simpler terms, an options contract allows you to speculate on the movement of an underlying asset without actually owning it.

Options contracts come in two main types: call options and put options.

Call Options

A call option gives the holder the right to buy an underlying asset at a specific price (strike price) at or before the expiration date. The holder of a call option expects the underlying asset`s price to rise, making the option profitable.

For example, assume a call option on XYZ stock has a strike price of $50 and an expiration date of 1st January 2022. If the stock`s price rises to $60 on or before the expiration date, the call option holder can buy the stock for $50 and sell it for $60, making a profit of $10 per share.

Put Options

A put option, on the other hand, gives the holder the right to sell an underlying asset at a specific price at or before the expiration date. The holder of a put option expects the underlying asset`s price to fall, making the option profitable.

For example, assume a put option on XYZ stock has a strike price of $50 and an expiration date of 1st January 2022. If the stock`s price falls to $40 on or before the expiration date, the put option holder can sell the stock for $50 and buy it back for $40, making a profit of $10 per share.

Other Types of Options Contracts

Apart from the basic call and put options, there are other types of options contracts that offer different risk and reward profiles. Here are some of the most common options contracts you might encounter:

1. American-style options: These options can be exercised at any time before or on the expiration date, providing more flexibility to the holder.

2. European-style options: These options can only be exercised on the expiration date, making them less flexible than American-style options.

3. Long options: These are options contracts that provide the holder with the right to buy or sell the underlying asset at a certain price and date.

4. Short options: These are options contracts that provide the seller with the obligation to buy or sell the underlying asset at a certain price and date.

5. Binary options: These options are a type of all-or-nothing option, where the holder receives a fixed payout if their prediction about the underlying asset`s movement is correct.

Conclusion

Options trading can be a lucrative way to diversify your portfolio and increase your returns. However, it is crucial to understand the different types of options contracts available and their associated risks and rewards.

By grasping the basics of options contracts, you can make informed investment decisions and potentially profit from market movements. As always, it is advisable to consult a professional financial advisor before making any investment decisions.