Options trading is a strong medium through which traders operate to hedge their risks, speculate in market movements, and earn profits. Traders must learn the different types of options to lay a strong foundation for the trading strategy. Here, the article will deal with the top four types of options any trader should know and their placement in the larger derivatives market, which encompasses types of futures contracts.
- Call Options
A call option gives the holder the right, but not the obligation, to buy an underlying asset at a specified price (the strike price) before or on the expiration date. Traders buy call options when they think the price of the underlying asset will go up. Call options can be sold to collect a premium in exchange for the obligation to sell the underlying asset if the option is exercised.
Call Option Example
A trader buys a call option on XYZ stock with a strike price of $100, and the put option expires in one month. The price of XYZ rises to $120. The trader, therefore, exercises the option and buys the stock at $100 intending to make a profit by selling it.
Call Option Advantages:
Unlimited upside potential.
Controlled risk (limited to the premium paid).
Options for hedging or speculation.
Call Option Disadvantages:
Loss of premium if the stock does not rise above the strike price.
Value may be eroded due to time decay if the asset price does not favourably move.
- Put Options
A put option empowers the holder to sell an underlying asset at a certain strike price before or on its expiration date, but it does not compel the holder to do so. If the holder expects the price of the underlying asset to decline, the trader will buy put options. If the put option is exercised, the put seller collects the premium with the obligation to buy the assets.
Put Option Example
A trader buys a put option on ABC stock with a strike price of $50. When ABC’s price drops to $40, the trader can exercise the option and sell at $50 to make a profit.
Put Option Advantages
Provides downside protection
Portfolio hedging
Limited risk for buyers (premium paid)
Put Option Drawbacks
Time decay could erode value.
Considerably less upside potential visually as opposed to short-selling (which essentially has no limit to the downside risk).
- American vs. European Options
American options can be exercised at any time before expiration while European options could only be exercised during expiration. So it is crucial to know these two definitions to make strategic trading decisions based on them.
Key Differences:
Flexibility: American options provide flexibility since they permit exercise at any time before expiration.
Premiums: The American option will tend to be priced at a larger premium on the flexibility.
Usage: Stock options traded in the U.S. would be American-style, while index options would often be European-style.
- Exotic options
These are different from others. They feature characteristics that are not found in traditional call and put options. Some of the common types are:
Barrier Options: They become active or inactive, once the price touches a predetermined level.
Binary Options: They pay out a fixed amount once either one of the conditions is met.
Asian Options: The payoff is based on an averaged price of the underlying asset for a certain period as against the price at a single point.
Bermudan Options: They are a cross between American and European options because they can be exercised on any date before expiration.
Conclusion
Precious knowledge about types of options is vital for successful trading practices. Call options, put options, American and European options, as well as exotic options are an understanding of options that will lead to opportunity identification and risk management. A knowledge of options and the various types of futures contracts can give the trader a comparative approach to participating in the markets. Thus, financial decision-making is just another step in offering traders an avenue toward diversifying their portfolio.
