A Comprehensive Guide To Options Contracts

Options trading is a type of derivative trading. It involves the buying and selling of the underlying price of an asset instead of the asset itself. In other words, when traders trade options, they are simply buying a contract that speculates on price movements and they do not own the underlying asset itself.

Options trading has become popular in recent years due to their flexibility. Options traders can speculate and find opportunities in both bullish and bearish markets. They can also speculate on a wide range of instruments without having to purchase the asset itself.

If you are looking to participate in options trading in Australia, there is a lot you can consider before dipping your toes in the market.

Definition of an options contract

First things first, it is important to understand what an options contract is. In simple terms, an options contract gives holders the right ? but not the obligation ? to buy and sell an asset at a fixed price on or before a predetermined date.

Traders can purchase options contract with the use of a premium ? this is a small amount of money. If they speculate on the market and they are wrong, they may forfeit their right to buy or sell the asset and suffer only the loss of the premium. This is a great incentive for those who prefer to invest yet have a lower risk appetite.

Types of options contracts

Calls and puts

There are two general types of options contracts that investors can buy ? calls and puts. A call option is a contract to buy, and a put option is a contract to sell.

When an investor purchases a call option, they are effectively purchasing the right to buy an asset at a fixed price on or before a predetermined date. Conversely, when an investor purchases a put option, they are effectively purchasing the right to sell an asset at a fixed price on or before a predetermined date.

American- and European-styles

Investors can also classify options by how they can be exercised. They give them the names American-style and European-style options.

An American-style option is a contract that allows the buyer to exercise the option at any time before the expiration date. This creates a bit more flexibility than a European-style option. The latter is a contract that allows the buyer to exercise the option only on the expiration date, which may be a bit more constricting.

The anatomy of an options contract

To know how an options contract is valued, we can break down what an options contract consists of.

Underlying asset

The underlying asset is the instrument on which an investor is speculating. This can be a stock, a commodity, an ETF, or anything that can be traded as an option.

The position the investor has taken

Next, you will see either a call or put, and this indicates the position the investor has taken ? if they want to buy or sell the underlying asset.

Strike price

You will also find something called the strike price. This is also called the exercise price as well, and it is the predetermined price at which the investor will buy or sell the underlying asset.

Expiration date and exercise style

Additionally, you will find the expiration date and the exercise style of the contract ? which can either be American or European. The expiration date is predetermined and agreed upon by the buyer and the seller as well, and it is when (or before when) the investor can buy or sell the underlying asset.

Contract size

After that, you will find the contract size. This refers to the amount of the underlying asset that one options contract represents. An options contract of stocks is always 1,000 shares. If an investor wants to buy or sell 5,000 shares of a stock, they will have to buy 5 contracts.

Settlement method

Finally, you will see in the contract an outlined method of settlement. Options can be settled physically or through cash. Physical settlement refers to a physical delivery between the contract writer and the holder, whereas a cash settlement refers to a cash transfer of the price difference between the strike price and the underlying asset.

The valuation of options

Knowing what an options contract is made of, traders should know that each options contract has value. This can be split into two types: intrinsic value and time value.

Intrinsic value

Intrinsic value refers to the part of the option?s value that is in-the-money, or otherwise referred to as ITM.

Time value

Time value refers to the remainder of the options? value. Many traders also refer to it as the hope value. This is the value based on the amount of time left before the contract expires and the underlying asset?s price.

What this means for call options

A call option is ITM when the underlying asset price is greater than the strike price. Conversely, it is out-of-the-money (OTM) when its underlying asset price is lower than the strike price. This means that the options contract has no intrinsic value.

When the strike price and the underlying asset price is the same, the call option is at-the-money (ATM).

What this means for put options

The same can be said for a put option, just inversely.

A put option is ITM when the underlying asset price is lower than the strike price. Conversely, it is OTM when its underlying asset price is greater than the strike price, rendering the contract without intrinsic value.

When the strike price and the underlying asset price is the same, the put option is ATM.

Making the most of your options contract

When you buy an options contract, there are many factors to consider. Outside of the traditional elements such as the underlying asset price, traders can and should do their best to make the most of their contract premium. There are three main factors that affect the price of a premium.

The first, of course, is market volatility. When the market is volatile and there are chances of great increases in stock price, an options contract will be more expensive. When the market is volatile with a great deal of hesitancy and no clear indication of how things will turn out, an options contract may be less expensive.

Interest rates also affect how options contracts are priced. When an economy is doing well and the government is strong, there is also such a thing as risk-free interest rate. Finally, you have to consider the dividend payable. For example, when you trade a stock that gives out dividends, it will have an effect on the premium price.

Should I trade options?

Knowing what you know now about options contracts, you may be wondering if you should trade options. There is no set answer to this. Aside from knowing how options trading works, you should also consider your risk tolerance, the amount you can afford to trade, and your preferences.

Why you might want to trade options

Options trading is relatively versatile, as you can speculate on the price movements of many instruments. There is also versatility in the price direction on which you speculate; you can find opportunities in both bullish and bearish markets.

Why you might not want to trade options

Options contracts are not complicated. However, you may not want to trade options if you are an investor who prefers buying and holding investments instead of trading them quickly. This is because options contracts have clearly defined expiration dates. Most traders who participate in options trading are short-term traders who strike when the iron is hot and stay away the rest of the time.

Conclusion

Whether you should trade options is entirely dependent on your trading plan, objectives, and preferences. If you would like to learn more about options trading, be sure to do your research and the instrument on which you wish to speculate. You should also do well to remember that there is always risk involved in all forms of trading.

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