Before you start trading in options it is important to first understand what option are. Options are contracted that gives you the right but not the obligation to buy or to sell an asset at a future date at a predetermined price. These are contracts that are binding in nature and the terms here are clearly defined.
The options are contracts that have terms that are clearly defined and these are used by investors for various reasons.
Options are divided into the call and put options. Ina call option the buyer of the contract has the right to buy the asset at a predetermined price in the future. The price is called the strike price or the exercise price. The put option is where the buyer has the right to sell the underlying asset in the future at a predetermined price.
The call option
The call option is a deposit that you make for the future purpose. For example, suppose you want to buy a land in the future but you will buy only if certain laws are in place.You can buy the call option to buy the plot at say $500000 in the next 3 years at any time. The owner will not give you this option for free and he will need you to make a contribution in order to give this right to you. This is known as the premium and this is the contact options price.
This is the premium amount that could say $10000 that you will have to pay to the owner. Suppose after two years the laws have been passed in your favor and you decide to exercise the option. You go ahead to buy the plot for $500000 even though the price of the plot has doubled now.
It could also happen than the laws have not been passed and it is has passed say in the 4 the year after you had exercised the option. Now you will have to pay the market price. The landowner will however not give back the $10000 that you had paid.
A put option is like an insurance policy. You may have a host of blue-chip stocks and you are worried that there will be are a session in the next two years which will cause the price to go down. You want to be sure that in case this happens then you do not lose more than 10%. In this case, you will purchase a put option to sell the index at say 2500 at which it is currently trading in. You can exercise the put option anytime in the next 2 years.
If suppose in the six months’ time the markets crash by say 20% that’s 500 points lower then you can sell at 2250 even when the market is at 2000. Thus you have made 250 points. This is a combined loss of just 10%. So even if the market goes down to zero, all that you will lose is just 10%.Again you will have to pay a price that is a premium to purchase the put option. If the market, however, does not drop then you lose out the premium amount.