Types of Options Contracts?

Traders continually seek ways to diversify their portfolios and hedge against potential losses. One popular financial instrument for this purpose is options trading. An options contract provides buyers with the right, but not the obligation, to buy an underlying asset at a specified price on a future date.

Since these underlying assets can include stocks, bonds, ETFs, and commodities, options contracts offer a way to diversify and potentially profit. In this article, we will cover different types of option contracts.

Call Options

A call option is an options contract that grants the holder the right, but not the obligation, to purchase a specified underlying asset at the strike price before or on the expiration date.

Traders purchase call options in underlying stocks when they anticipate that the price of the underlying stock will rise before the option expires.

Suppose you buy a call option for Stock XYZ with a strike price of ₹100 and an expiration date one month away. The cost of the option (premium) is ₹5 per share.

• If Stock XYZ rises to ₹120 before the expiration date: You can exercise the option to buy the stock at ₹100 and immediately sell it at ₹120. Your profit per share is ₹120 - ₹100 - ₹5 (premium) = ₹15.
• If Stock XYZ stays below ₹100: The option expires worthless, and you lose the ₹5 per share you paid for the option.

In this way, call options can offer significant profit potential with limited upfront cost, but they also come with the risk of losing the premium paid if the asset doesn’t rise above the strike price.

Basically, there are two types of call options: 

1. Long Call Option: This gives the buyer the right, but not the obligation, to buy the underlying asset at a specified price on or before a future date.
2. Short Call Option: This involves the seller agreeing to sell the underlying asset to the buyer of the call option at a specified price on or before a future date.

To effectively navigate this complex market, it's crucial to learn option trading.

Put Options

Put options are financial contracts that give the holder the right, but not the obligation, to sell a specified underlying asset at a predetermined price (the strike price) before or at the expiration date.

Traders buy put options when they anticipate a decline in the price of the underlying asset.

Suppose you purchase a put option for a stock of Company XYZ with a strike price of ₹500, and the option premium (cost) is ₹20 per share.

• If the stock price falls to ₹450 before the option expires: You can exercise your option to sell the stock at ₹500, even though it’s currently worth ₹450 in the market. You make a profit of ₹30 per share (₹500 strike price - ₹450 market price - ₹20 premium).
• If the stock price stays above ₹500: The option becomes worthless, and you lose the premium paid, which is ₹20 per share.

This strategy is useful for hedging against potential declines in asset prices or speculating on downward movements.

There are two types of put options:

1. Long Put Option: With a long put option, the buyer acquires the right, but not the obligation, to sell the underlying asset at a specified price before a set date. This strategy is used when the buyer expects the asset's price to fall.
2. Short Put Option: In a short put option, the seller agrees to buy the underlying asset at a specified price before a set date if the buyer chooses to exercise the option. This strategy is employed when the seller expects the asset's price to rise or remain stable.

Conclusion

Understanding the different types of options contracts can significantly enhance your trading strategy. Each type offers unique benefits depending on your strategy and market outlook. For those new to options trading, learning the basics can significantly boost your confidence and success. Upsurge.club offers several courses on option trading for beginners, providing a great starting point to develop your skills and knowledge.