Chapter 3: Types of Options Contracts
There are primarily 2 types of Options that are traded:
- Call Options
- Put options
1. Call Options
A call option gives the holder the right, but not the obligation, to buy an underlying asset at a specified price (“strike price”) within a specified time period. The seller (“writer”) of the call option is obligated to sell the underlying asset at the strike price if the holder decides to exercise their right.
A call option is bought by bullish traders, meaning a trader will buy a call option assuming that the prices of the underlying asset will increase on or before expiry. Call option buyers may buy to hedge and mitigate price risk or want to speculate but take a limited risk if things go south.
Wondering why buying a call option has limited risk? It’s because the maximum loss to a buyer of any options contract can be the premium that is paid to buy that option contract.
2. Put Options
A put option gives the holder the right, but not the obligation, to sell an underlying asset at a specified price (the strike price) within a specified time period. The seller (“writer”) of the put option is obligated to buy the underlying asset at the strike price if the holder decides to exercise their right.
A put option is usually bought by Bearish traders, meaning a trader buys a put option assuming the prices of the underlying asset are about to decrease on or before expiry.
The buyer of a put option can be anyone such as an investor, who is either buying the put option to hedge and mitigate price risk that may occur due to the fall in prices of the underlying asset.
OR
A trader who wants to speculate and participate in the bearish trend but wants to take limited risk in case if the view of the trader goes wrong.
Both call and put options can be bought or sold and can be used for a variety of investment and trading strategies. There are also several other variations of options contracts, including:
American options: These options can be exercised at any time before the expiration date.
European options: These options can only be exercised on the expiration date.
LEAPS options: These are long-term options that have expiration dates that are more than one year in the future.
Weekly/ Monthly options: These are options that expire every week instead of every month.
It is important for traders to understand the specific features and risks associated with each type of options contract before engaging in options trading.
Underlying Asset in Options Trading
As a trader, wouldn’t you want to know what are the alternatives of the underlying asset available in the F&O markets, that one can trade with these options?
Options contracts are traded in the following underlying assets –
- Stock Options
- Index Options
- Currency Options
- Interest Rate Options
1. Stock Options
Stock options are options contracts which have individual stock as the underlying . Stock Options are widely used by various market participants such as investors , traders, hedge funds etc to either manage their risk of all the open un hedged position or sometimes for speculative purposes too. Stock Options are traded in Lot sizes on the futures on options segment of an exchange.
Stock Options have monthly expiry of their contracts and these contracts expire every last trading Thursday of the month.. If last Thursday is a trading holiday only then contracts expire on the previous trading day.
2. Index Options
Index futures are options contracts where the underlying asset is an index, like the Nifty50, Bank Nifty, or Finnifty in India. Comparable to stock options, they grant the buyer/holder the right, but not the obligation, to purchase or sell the underlying index at a predetermined price on or before a specified date.
The Index options market offers various contract expirations. For example, Nifty 50 options have four weekly contracts, three consecutive monthly contracts, three quarterly contracts for March, June, September, and December, and eight semi-annual contracts for June and December.
This ensures that options contracts with a minimum of four-year tenure are available at any given time. Let’s take the start of the Financial year as the base. Contracts that are available are as follows –
After each weekly contract expires, a new serial weekly options contract is introduced. When the near-month contract expires, new contracts (monthly, quarterly, or semi-annual) are introduced with fresh strike prices for both call and put options. This occurs on the trading day following the expiration of the near-month contract.
The monthly contracts for Nifty 50 options expire on the last Thursday of the expiration month, while weekly contracts expire every Thursday. In the event of a trading holiday on Thursday, the contracts expire on the previous trading day, similar to stock options.
Similar to Nifty 50 options, Bank Nifty options have the following –
Finnifty, a relatively new Index gaining popularity these days, has a different expiry date and has the following contract cycle.
However, it’s a relatively new index and the long-term contracts have lesser volumes currently.
Lot sizes in Index Options in India –
3. Currency Options
Currency options are one of the most widely used instruments for businesses, individuals, and financial institutions to protect themselves against exchange rate fluctuations.
Currency options give the buyer/holder to buy or sell a specific amount of one currency for another at a predetermined exchange rate (the “strike price”) on or before a specified date.
There is no obligation for the buyer of the options contract to meet the contract commitments in case the buyer doesn’t wish to, as the buyer has the right to exercise the option of buying or selling on or before expiry. After all the buyer pays a premium to get this right.
Currency options can be used by investors, traders, importers, and exporters to manage currency risk, speculate on exchange rate movements, or create complex financial products.
4. Interest Rate Options
Interest rate options are options whose underlying asset is an interest rate, such as the 91-day Treasury Bill (T-Bill) rate or the 10-year government bond yield in India.
Interest rate options provide the buyer/holder with the right, but not the obligation, to purchase or sell the underlying bonds at a predetermined interest rate on or before a specified date.
These options can be used to manage interest rate risk, speculate on interest rate movements, or create complex financial products.
Interest rate options can be based on different types of government bonds, short-term interest rates, or other financial instruments that are sensitive to changes in interest rates.
With this we come to an end to this Chapter. In the next Chapter we shall discover how option premiums are priced ?
See you in the next one!