An option is one of the complex financial instruments, which is a contract that gives the trader the right to buy or sell a certain asset at a given price at a specified time. This investment instrument is used to hedge risks and make profit from speculative transactions. There are two types of option agreements: put and call.
What is a put option
A put option is a futures contract that gives its buyer the right to sell assets at a predetermined price at a predetermined time.
If an unfavorable situation arises (for example, a forecast of an upcoming reduction in price or price reduction), the trader has the right to sell the contract earlier than the agreed date. The decision to sell a financial instrument is made solely by its owner and may depend on current sentiment on the stock exchange. In this case, the buyer is obliged to purchase the asset, even if it is not profitable for him at the moment.
What is a call option
A call option is an agreement that operates inversely to a put option. It gives the buyer the right to purchase an asset at a pre-agreed price at a certain point in time, in the buyer’s interest for the asset to rise in price before the end of the contract period. If the situation develops unfavorably, the trader has the right to change his decision and refuse to purchase the underlying investment instrument. In this case, the seller has no right to choose. He is obliged to sell the asset at the first request of the buyer.
The compensation to the seller upon completion of the transaction is offset by an irrevocable premium. A certain amount is paid to the owner of the securities during the process of concluding the agreement and is not refundable, regardless of whether the agreement is fulfilled within the agreed period or the other party to the transaction changes his mind about buying the asset.
Difference between put and call options
The main differences between put and call contracts are:
Under the terms of a call agreement, the trader is given the right (but not the obligation) to purchase an asset on a certain date at an agreed upon price. A put gives the trader the right (without obligation) to sell an asset at a predetermined price at a specific time.
A call option makes a profit if the price of the underlying asset rises. The difference between a put option and the previous one is that it provides benefit when the value of an asset falls.
The buyer’s potential profit from transactions with call agreements is unlimited. In the case of put contracts, there is already a return limit on the holder’s income.
Despite the many significant differences between these investment instruments, the maximum loss from transactions with both types of contracts is not limited for the seller, and for the buyer is determined by the size of the premium.
Where are these options used?
Options are often used in speculative trading strategies. But due to the fact that this instrument is highly complex and involves an uneven distribution of risks between the seller and the buyer, many traders prefer futures.
The second important application of put and call contracts is hedging. This is the protection of investments from the risk of adverse changes in the value of assets using derivative financial instruments. Options contracts are ideal for this purpose.
If an investor wants to insure his investments against rising prices for underlying assets, he takes a long position (concludes a call option agreement). A put option works in a similar way to hedge the risk of a decline in the value of financial instruments.
Real stock options have nothing to do with so-called binary options
. The latter are mainly used by fraudulent companies that do not provide traders with the opportunity to earn money, but are focused only on taking money from them.
Options are used for hedging due to the use of an unsecured margin trading mechanism (leverage). As a result, options trading involves high risk.
Options are more often used by large investors, such as hedge funds. Private investors use them to make speculative profits. At the same time, there are many options trading strategies that actually break even. However, in order to succeed, you need to strictly follow their rules.