An option contract gives the buyer the right, but not the obligation to buy/sell an underlying asset at a pre-determined price on or before a specified time. The option buyer acquires a right, while the option seller takes on an obligation. It is the buyer’s prerogative to exercise the acquired right. If and when the right is exercised, the seller has to honour it. The underlying asset for option contracts may be stocks, indices, commodity futures, currency or interest rates
What are the types of options?
Broadly speaking, options can be classified as ‘call’ options and ‘put’ options. When you buy a ‘call’ option, on a stock, you acquire a right to buy the stock. And when you buy a ‘put’ option, you acquire a right to sell the stock. You can also sell a ‘call’ option, in which, you will acquire an obligation to deliver the stock. And when you sell a ‘put’ option, you acquire an obligation to buy the stock.
What do you understand by the term option premium?
Option premium is the consideration paid upfront by the option holder (buyer of the option) to the option writer (seller of the option). The option holder gets the right to buy / sell the underlying.
What is the strike price or the exercise price of the option?
The right or obligation to buy or sell the underlying asset is always at a per-decided price known as the ‘strike price’ or ‘exercise price’, which is linked to the prevailing price of the underlying asset in the cash market. Usually, option contracts are available on the underlying asset on various strike prices (generally, five or more)-divided equally on either side of its spot price.
How does an American option differ from a European option?
In ‘European’ options, a buyer can exercise his option only on the expiration date, that is, the last day of the contract tenure. Whereas in ‘American’ options, a buyer can exercise his option any day on or before the expiration date.In the Indian equity market context, index options are European style, while stock options are usually American in nature.
How do options differ from futures?
- In futures, both the buyer and the seller are obligated to buy and sell, respectively, the underlying asset-the quid pro quo relationship. In case of options, however, the buyer has the right, but is not obliged to exercise it. Effectively, while buyers and sellers face a…
- linear payoff profile in futures, it’s not so in the case of options. An option buyer’s upside potential is unlimited,while his losses are limited to the premium paid. For the option seller, on the other hand,his maximum profits are limited to the premium received, while his loss potential is unlimited.