Chapter 2: What are Options Contracts?

Options are standardised derivative contracts traded on recognized stock exchanges like NSE and BSE which derive their value from an underlying asset.

There are 2 parties to the contract:

Buyer

Has the right but not an obligation to buy or sell an underlying asset which can be a stock, commodity, currency, or even an index, at a predetermined price (aka Strike Price) on a predetermined date (aka Expiry). To buy this right, option buyers have to pay a premium.

Seller

The counterparty that gives this right to the buyer and receives a premium for the option sold.

Yes, you heard it right, the buyer of the option has the right and not an obligation to buy or sell the underlying asset. The seller also known as the option writer has the obligation to sell/deliver the underlying asset as per the contractual agreement. 

Furthermore, there are two types of options contracts:

  • Call Option: The right to buy an underlying asset at a predetermined price on a predetermined date. 
  • Put Options: The right to sell an underlying asset at a predetermined price on a predetermined date.

We shall discuss this in-depth and understand how these option contract types work in the next Chapter. 

Options were created to manage the one thing we all are scared of, which is risk. But today options are used not only to manage risk but also to speculate or to hedge traders and investors against volatility. 

Let’s decode the concept of Options by the very definition.

Options

Options are “Standardised Derivative Contracts” traded on “Recognised Stock Exchanges “ – since options derive their values from their underlying asset or stocks on which the options are based. Since these are traded on exchanges , these contracts have standardised terms and conditions defined by the exchanges on which they are traded.

Option Buyer

The buyer of the Option has the “right to buy or sell” and not an obligation to do so, this means the buyer of the option can choose to buy or sell the underlying asset  from or to the seller of the option only if they wish to. Buyers therefore can use option buying as a hedge against price movements or volatility in the price movements of the underlying asset.

Option Seller

The seller in an options contract is the trader who has given the right given to the buyer for buying options. An Option Seller also known as Option Writer has to abide and by default oblige to deliver based on the terms and conditions mentioned in the contract. 

Premium

Option Premium is what a seller receives from the buyer of the options.

Strike Price

The Strike Price is the price at which the buyers and sellers agree to buy and sell the underlying asset. Strike Prices are usually fixed in multiples or round figures and are set by the exchanges, to standardise the contract agreements.

 

The strike price is also known as the “Exercise Price” since the buyers choose to exercise their right to buy or sell at the chosen strike price. 

Expiry

Expiration Date or Expiry of the options contract is the end period of the contract after which the contract gets terminated or null and void. Compulsory settlement as per the terms and conditions needs to be fulfilled post the expiration of the contract.

Now that you know what option contracts are, let’s jump to the meaning of option trading. 

What is Options Trading? 

Options trading is the activity of buying or selling “Options” in the futures and options segment of an exchange. 

If traders have a bullish bias towards any underlying asset and therefore are buying a CALL Option which is the Right to Buy.

Similarly, if theres is a bearish view towards an underlying asset and therefore are buying a PUT Option that is the Right to Sell  the underlying asset based on that bias, they are trading in options.

Options Trading is a high-risk high-reward domain as it involves leverage. Remember we discussed the significance of leverage in F&O markets? Options contracts are no exceptions and most traders flock to options trading because leverage helps increase ROI and compounds the money faster. 

Where are Options Traded? 

Option Contracts are Exchange Traded. You can find them on recognized stock exchanges. In India, there are 2 major stock exchanges that see significant volumes of options contracts traded daily: 

  • The Bombay Stock Exchange  (BSE) 
  • The National Stock Exchange (NSE) 

Out of these 2 exchanges, NSE has the highest volumes in terms of Total Turnover in the F&O markets. A boom in Options trading in India was witnessed in early 2000 when the NSE launched Index Derivatives on the popular benchmark Nifty 50 Index. 

Since then, a wide variety of product offerings in Indexes and Equity derivatives has increased the popularity and volumes of options trading. The exchange currently provides trading in F&O contracts on 4 major indices and close to 200 stocks.

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