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Basics of Options Trading

An options is a kind of derivative product that may be purchased or sold at a specific price within a pre-determined time period against an upfront non-refundable deposit. An options contract provides the right but not an obligation to purchase at the specified price or date.

Using options

You may use options trading for the following purposes.

  1. Leverage

You are able to benefit from the price of securities without blocking your entire investment. Furthermore, you are able to control the security without purchasing it outright.

  1. Hedging

Options help you hedge your risks against price movements of the securities. These provide you with the choice to buy or sell the security at a pre-determined price within a specified period.

Common terms

Trading is these derivatives have its benefits. However, it is important to understand the basics and constantly monitor market movements. Here are six commonly used terms in options trading.

  1. Premium

This is an upfront payment made by the buyers to the sellers for availing the rights under the options contract.

  1. Exercise/strike price

It is the pre-determined price at which you may sell or buy the underlying asset.

  1. Expiration date

It is the date on or before which you must exercise your option. The contracts include three durations; near month, middle month, and far month.

  1. Lot size

It is the fixed number of the underlying security units that are included in a single options contract. Standard lot sizes vary for each asset and are determined by the exchange where these are traded.

  1. Open interest

This refers to the number of outstanding positions for particular options across all the participants at a specific point in time. The open interest is nil after the expiration date for a particular contract.

  1. American and European options

These are classified based on the underlying asset within the options contract and time when it may be executed. American options may be executed any time on or before the expiration date. European options may be executed only on the expiration date. India uses only European options.

Types of options

Such trades are classified as Call and Put Options. Here is a brief overview of these two types.

  1. Call Option

These contracts provide you with the right to buy a particular underlying security of product at the strike price on or before the expiration date. You need to pay the premium upfront at the time of entering the contract. Such options increase in value if the value of the underlying asset rises.

  1. Put Option

This offers you the right to sell the underlying asset or product at the strike price at any time prior to the expiration date. Because the option may be executed anytime, you are protected in case the spot price falls below the strike price. Therefore, put options increase in value if the price of the underlying asset decreases.

The transactions of options contracts are recorded in the exchange through which such transactions are routed. Although options have their advantages, trading in this instrument is more complex than dealing in regular shares, so it is necessary to have a good grasp on trading and investment practices.

About Vikas Agarwal

Vikas Agarwal is an IIT-Varanasi graduate in Chemical Engineering. He is the Founder and CEO of Finaacle.com - an investment advisory website. He is a Business Development Professional but a Value Investor at heart. He writes articles on Finaacle, which focus on simplifying the art of investing and the causes of human misjudgment when it comes to investing. He also shares his experiences as an investor and lessons from some of the greatest investors of all time.

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