Options are a kind of derivatives. Options are traded on a registered exchange. Nowadays, options are commonly traded in an online mode through option brokers. It must be remembered that derivative are basically of two types (a) Futures and (b) Options. Hence, one must not try to project the characteristics of futures on the options trading.
Options are offered on various financial instruments like stock, foreign exchange, commodities and most importantly, the market indices. There is no need to hold these assets at all. There is no need to take their delivery. Hence the assets on which the options are offered are called as ‘underlying asset’ or simply ‘underlying.
There are basically two types of options:
(a) Call Options
(b) Put Options
Buying a call option means getting into an agreement to buy the underlying asset in future at a pre-determined price. The buyer of call option has to pay the premium to the writer (seller) of the option
Buying a put option means getting into an agreement to sell the underlying asset in future at a pre-determined price. The buyer of sell option has to pay the premium to the writer of the option.
The buyer of the option (call as well as put) can either exercise the option or waive it depending on whether it is favorable for him. The writer of the option, however, has to mandatorily perform his obligation if the buyer decides to exercise the option. He cannot waive the option contract.
Judicious use of both, call as well as put options, can help to create unlimited combinations of option strategies. Options strategies can return an unbelievable profit, whether the market is moving up or down. Moreover, one can remain in profit when the underlying asset remains stagnant for a considerable period of time.
Following are some of the important benefits of option strategies
(a) Protection and Hedging :- Whenever the market moves against you, an option trader makes a lesser loss than a trader operating in the cash market. This is because in option trading, your maximum loss is locked in to the price that you have paid for buying the option which is again not more than 10% of the price of the stock. Thus, option trading provides an excellent protection and a hedge to your other positions in the market.
(b) Leverage: One of the greatest benefits of option trading is that you can make multiple time profits by investing only a small sum of money. This leverage is is not a fixed amount of leverage but a variable one which you can use by choosing different strike prices or expiration period of the option. Option trading allows traders to participate in larges moves in the market despite having a limited capital with them.
(c) Flexibility:- Even a slight move in the underlying asset can yield you gains. Whatever be the movement in the market, or even if it is stagnant, a smart combination of option strategies can give you profits. An option trader can buy a put option if he expects the market to fall. This way, he will not risk his margin with the deposit by playing short in the cash market or by selling futures.
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