Types of Options

Primarily two types of options are available in the derivatives market:

1. Call Option

In a Call option contract, the holder (buyer) has the right to buy the underlying asset at a pre-determined agreed-upon price, known as the strike price (exercise price). The holder needs to exercise the option contract on or before the expiration date mentioned in the contract. Investors exercise the call option if they anticipate that the price of the underlying asset will increase in the future. Hence, the option will be valid if the investor can buy the asset at the strike price which is lower than the market price of the asset at the date of exercising the agreement. On the other hand, if the market price (spot price) falls below the strike price, the contract is not exercised and it becomes invalid. In addition to this, call options can be either short (sell) or long (buy) depending on the investor’s agreement.

2. Put Option

In the Put option, the holder has the right to sell the underlying asset, but no obligation, on or before the expiration date at the pre-specified strike price. A put contract allows investors to anticipate a decline in the future price of the underlying asset. It allows them to sell the asset at a higher price than the market price.

Apart from the above two, based on the expiration date, two forms of options are designed. American Option and European Option. In the American option, the holder can exercise the option at any time before the expiration date. While the European Option can only be exercised at the time of expiry. Early exercise is not possible in the European option before the specified date. Hence, the American option has a greater advantage as investors can look for strategic opportunities based on the market price movements between the date of purchase and the date of expiry. Nonetheless, most of the stock index options are designed under the European type because the early exercise option (American option) carries a larger premium than the later type (European option).

Options, in the derivative market, are a type of financial instrument that helps to purchase high-valued underlying assets at a comparatively lower price, potentially generating considerable profits. The underlying assets refer to stocks, indexes, exchange-traded funds (ETFs), or commodities. The options are contracts bought and sold by the ‘buyer’ based on the type of contract, i.e., the underlying asset. These contracts have a particular expiration date within which the holder of the contract must exercise their option. In options trading, the buyer is called the ‘holder’ of the contract. The mentioned price of an option is termed the strike price or the exercise price. The options are usually bought and sold via retail or online brokers. In addition to this, options contracts are not obligated to exercise the contract, unlike other derivative products (forwards or futures).

Geeky Takeaways:

• Definition: Options are a type of derivative contract that provides the ‘holder’ the right to buy or sell, but not the obligation, an underlying asset or a financial instrument at an agreed-upon exercise price on or before a specified date based on the type of option (index, stock, commodities or ETFs).
• History: Initially, options were used for olive harvest speculation in ancient Greece. Current options (used for investment) were first published in the Chicago Exchange. Later in 1973, the European Options Exchange was formed in Amsterdam.
• Types: Basically, there are two types – call and put options, which form the basis for a broad range of option strategies developed for generating income, hedging, or speculating.
• Benefit: Options have multiple opportunities to earn profit, but by carefully weighing their risks. It is a complicated derivative product that provides multiple advantages compared to stocks or ETFs.