Investors may have heard of the F&O area of investment, but may have never tried to understand what it is. A part of futures and options trading, options are contracts to buy or sell an underlying asset (as mentioned in the contract) at a fixed price prior to or on an expiry date. The price and date are set in advance. To grasp the nature of the different types of options contracts, investors should have a clear idea about the basics of options themselves.

What are options contracts? - Some Basics First

Essentially, an options contract is an agreement that takes place between two parties, a buyer and a seller. The agreement is to buy or sell an underlying asset, which could be a stock, index, or a commodity, at a predetermined price (the strike price) by a specific date, the date of expiry of the contract. The buyer or the seller has the right to buy or sell the contract before or on the date of expiry, but is under no obligation to do so.

To put it simply, options comprise financial instruments that are typically based on the value of the underlying securities in any options contract. So, it is actually the underlying asset which is bought or sold at a predetermined price on a date which is stipulated in advance. The underlying assets could be any commodity or a set of stocks.

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What are options used for?

Before you understand the types of options, you should know why options are chosen as instruments of investment. Generally, options are used to hedge positions, but options can be used for speculative purposes as well. Using options contracts offers a kind of leverage to investors, permitting investors to take a chance on a stock without actually buying or selling the stock outright. However, in exchange for such a privilege that investors get from options contracts, the buyer of an options contract must pay a premium to the seller of the options contract.

Types of Options Contracts

Basically, there exist two types of options contracts: puts and calls. Both may be bought in order to speculate on the particular direction that the underlying asset/security is moving in. Similarly, both kinds of contracts may be purchased in order to hedge the exposure of the investor. Furthermore, both types may be sold in order to generate some income.

Typically, call options may be bought as a kind of leveraged bet made on the appreciation of an index or a stock. Put options are typically bought to profit from prices declining. What investors should grasp is that the buyer of a call option has a right to purchase the number of shares that the contract stipulates, at the strike price, but no obligation to do so. On the other hand, put option buyers have a right to sell the underlying asset/stock at the strike price, but no obligation to undertake the sale.

Understanding More About Puts and Calls

After investors have understood the concepts relating to the types of options, it's worth going into a little more detail about call option contracts and put option contracts.

• The Call Option Contract

In a call option contractual transaction, a position may be opened when contracts are bought from sellers. In the process of the transaction, sellers are paid premiums so that the obligation of selling shares at a particular price (strike price) is assumed. If the seller holds on to the shares that have to be sold, the position is known as a covered call.

• The Put Option Contract

What the buyers of put options are doing is essentially speculating on the declining prices of the underlying assets/stocks. They have the right to sell assets or stocks at the strike price which is specified in the options contract. In case the price of shares, say, drops under the strike price before the expiry date, the buyer may then assign stocks to the seller to buy at the strike price, or may sell the options contract in case the stocks are not held within the portfolio.

American and European Options - What are they?

Types of options contracts may also be categorised on the basis of the way they are executed. These “styles” of executing options contracts are divided into American options and European options.

• American Options

Option contracts which may be executed at any time prior to the expiry date are known as American options. Only select American options securities are available at the National Stock Exchange (NSE).

• European Options

These are options that can only be executed on the date of expiry of options contracts, and not before the date. All the index options which are traded at the National Stock Exchange (NSE) fall into the category of European options.

Opting for Options

Options contracts and trading in options offer investors some advantages. The low cost of entry to take positions, the hedge against risk and the sheer flexibility are all appealing to investors who would like to try options trading for the first time. In any event, when investors do choose to trade in options, it is essential to do some research before starting investment, besides assessing one’s own investment goals.