What are Option Contracts in Stock Market?

Options are a type of derivative financial instrument between two parties who contractually agree to transact an asset at an agreed price before a future date. An "option" provides its owner the opportunity and right to either buy or sell the asset at the exercise price, but the owner is not bound to exercise (buy or sell) the option. If the option reaches its expiration date without being traded, it becomes useless without any value.

Basically, two types of options are there in the market −

  • Call options – Call options let the option holder buy an asset at a specified price before or at a certain timeframe.
  • Put options – Put options allow an option holder to sell an asset before or at a particular time at a specified price.

A call option holder anticipates that the value of the underlying asset will go above the exercise price (strike price) before expiry. On the other hand, a holder of a put option expects that the value of the underlying asset will go below the exercise price before the expiry date.

Option Premium

The price of an option charged by the writer or sold on an exchange market is known as the "option premium." The option value is found from its intrinsic value (the difference between present market rate and future strike price) plus the level of price volatility plus the time value.

  • The option prices will generally go above their pure option value due to reasons such as the seller’s incentive to maximize returns. Also, transaction charges and capital gains taxes may be charged too.
  • Prices are also dependent on the relationship between the company and the bank. Moreover, the average costs may be reduced by negotiating a bundle of services from banks.
  • Combining both call and put options allow companies to set the options at their own rates in sync with their views on rate movements and to suit the financial needs.
  • The premium a company pays can be mitigated by the premium the bank pays for the option the company sells.
  • In select circumstances, these premiums may cancel each other’s cost out and the net cost to the customer becomes zero.

Timeframe of Option Contracts

The timeframe for buying/selling an option may fluctuate depending on the cost and demand/supply dynamics. In standard option transactions at given prices, the timeframe is instantaneous. The case of complex derivatives that require negotiation on pricing tends to take a longer time. The timeframe for complex options may vary based on the assessment of the value of the structured solution and negotiations on pricing between OTC counterparties.

Option expiry dates can range from days to years. Expiry specifications on hedges are determined by the buyer’s requirement on the timeframe it needs to hedge.

Advantages of Option Contracts

  • The ability to hedge the risks from an adverse market change on assets with floating value.
  • Some structured solutions provide reverse positioning to profit from such changes.
  • The flexibility to estimate and profit from both positive and negative changes to the value of a security.

Disadvantages of Option Contracts

  • Complicated structures need expertise in utilizing options as a form of hedge or investment, creating the need to hire specialists or access the services of service providers.
  • Incomplete understanding of the risks involved in investing in options or using them as hedges may lead to substantial losses for an individual or a firm.