Novice traders have a particularly difficult time. After all, the stock market is replete with terms unfamiliar to them. You have to spend a lot of your own time and effort to figure it out and comprehend the theory of investment science. Let's find out what option contracts are. This is the term experienced traders have repeatedly come across. But for beginners, it may seem incomprehensible.
The concept
Options contracts are contracts under the terms of which one party acquires the right to buy an asset at a set price before a fixed date. This right for the seller becomes an obligation to buy or sell an asset at a predetermined value. It is worth noting that for this the buyer pays the seller an option premium. From here the similar name of contracts went. By the way, as a reduction, traders often call them simply options. This is important to know.
Kinds
Options contracts are contracts of several types. This information will also be useful for a novice trader.
- If an option provides the right to acquire an asset, it is called a call.
- If the contract provides the right to sell the asset, it is called put.
Each option has a fixed validity period, which is limited by its expiration date. Depending on this, Asian, European, and also American option contracts are distinguished. This needs to be clarified.
Asian provides the right to conclude a transaction between the agreed date and the duration of the option. European allows you to make a transaction related to the purchase or sale of an asset, but only on a certain day. The American is most loyal and provides the opportunity to use the right to purchase absolutely any day before the expiration of the option contract. It is important to know these conditions before making a transaction.
However, these are not all types of such contracts. They can also be standard or exotic. Standard (the second name is vanilla) are present on exchanges and generally fit into the concept of options. Exotic financial institutions issue in accordance with customer requests. In this regard, the terms of such option contracts can be absolutely any. That is why it is necessary to work with them especially carefully, carefully studying all of the above conditions.
According to the form of implementation, option currency contracts are divided into two types.
- With physical delivery. In this case, the owner receives a certain amount of underlying assets.
- With cash. In this case, the owner manages to get some difference, which is calculated between the price at the time of conclusion of the option contract and at the time of its implementation.
Option Features
Any type of contract has its own unique differences. Features of option contracts are that they can be used for risk insurance. In a sense, such contracts resemble the acquisition of insurance policies. They also pay a premium, which is called optional. This fee provides the buyer with a guarantee that the price specified in the contract will be fixed for a certain period.
There is an opposite side to any trade. When concluding an option contract, it is investors or speculators who take certain risks and get rewarded for this. This feature also resembles the principle by which insurance companies operate. It is curious that in the event unfavorable for the investor or speculator, there is the possibility of a reverse transaction.
It is important for a novice trader to understand that the financial responsibility of investors and speculators with whom the buyer enters into an option contract is potentially unlimited. Accordingly, in some situations, it may exceed the amount of funds that were originally invested.
Open positions under option contracts mean their total number, free under guarantee. You need to understand that each transaction requires both parties. This is both the seller and the buyer. The total number of open positions, which is changed and published daily, allows us to assess the tendency to increase or, conversely, decrease.
Stock options
They are types of option contracts. Concluded exclusively on exchanges, they are fully standardized and can be closed by reverse transaction. As a rule, they are short-term in nature. On average, the duration of exchange options does not exceed one year. In this case, the most common option is contracts with a validity period of three months.
OTC options
The market for these contracts is created by dealer banks, which simultaneously act as one of the parties to the transaction. They take on the role of a clearing house, with the difference that risk guarantees do not apply to the entire transaction market.
Specialists divide OTC options contracts into short-term and long-term ones. The latter, in turn, can be single-period or multi-period.
Cost of option contract
This indicator depends on several factors.
- Time until the end of the contract. The value of the option is lower, the closer the expiration date.
- Risk free interest rates.
- Option style. As noted above, distinguish between Asian, European, and American.
- Individual assessment of market participants.
It is worth noting that the cost of option contracts is also influenced by several other factors. As a result, their combination determines the final cost at which the transaction is concluded.
Options Benefits
There are several reasons due to the presence of which traders often prefer this type of contract.
- High profitability. The potential profit that can be obtained from the transaction under the terms of the option exceeds the amount of the premium paid by the buyer.
- The minimum risk that the buyer reduces is the loss of premium remuneration. Moreover, in exchange, he gets the opportunity to extract almost unlimited profits.
- Ability to choose a strategy. The buyer has a fairly wide selection. For example, no one forbids him to combine different contracts, conduct operations in parallel on several option markets, etc.
Futures and options contracts
Both concepts, one way or another, are present in the stock market, so they should be familiar not only to experienced, but also to novice traders.
What options are, you already know. It is time to learn about futures.
Under this term are sale contracts, the object of which is a certain amount of the asset. The peculiarity of the transaction is that it must take place on the agreed date at the price agreed upon by the parties at the time of signing the agreement.
In the futures contract there are two parties, namely the seller and the buyer. In accordance with the conditions, the latter bears the obligation associated with the acquisition of the asset. The seller, on the contrary, is responsible for the sale of the object of the transaction. Accordingly, after the conclusion of a futures contract, both parties have mutual obligations.
It is worth noting that such a deal has some important feature. Before the period the specified period has not yet expired, both the seller and the buyer have the full right to annul the obligations assumed. This is possible in two ways. In the first, after acquiring a futures, it can be sold. In the second, on the contrary, after the sale of the contract it can be purchased.
In general, futures trading is one of the varieties of the investment process, which allows traders to speculate in the conditions of constantly changing quotes.
What assets can be objects in futures contracts? We list the main ones:
- oil;
- gold;
- steel;
- wood;
- corn;
- currency, etc.
Every day, traders make an incredible number of futures transactions, the objects of which are the above products. However, in most cases, these transactions are made due to speculative goals. This means that traders try to buy assets cheaper, and then sell them at a higher price. It is extremely rare that the ultimate goal of acquiring futures is related to the receipt or provision of the specified asset.
Differences
Let's find out how the above contracts differ from the options that we talked about earlier.
The difference between the two concepts is quite significant. A futures contract imposes an obligation on the buyer to acquire an asset. Optional, on the contrary, only provides this right, the buyer is not obliged to buy it. He makes this transaction exclusively voluntarily. However, the option contract imposes on the buyer an obligation related to the payment of a premium in favor of the potential seller, due to which the transaction becomes profitable for him.
Comparing options and futures, it will be incorrect to contrast one another. Both contracts can be used in parallel, thus obtaining the highest profit from own investment activities. A novice trader should know about this.