Investment portfolios are often composed of diverse asset classes. These usually are stocks, mutual funds, ETFs, and bonds. Options are an additional asset class. If used appropriately, options trading offers numerous advantages that dealing in stocks and bonds alone do not. Before we address these benefits, what are options?

What are Options?

An ‘option’ is a contract that permits (but doesn’t necessitate) an investor to purchase or trade instruments like securities, ETFs or index funds at a pre decided rate after a specified period. Selling and purchasing options are carried out in the options market. An option that permits you to acquire shares sometime in the future is referred to as a “call option.” On the other hand, an option that enables you to sell shares sometime in the future is a “put option.”

Factors of how Options Work

Following are a few factors which can determine the options prices.

• Existing price
The existing or current price of the stock is crucial when you determine the options price. The current price of the stock and the cost of the option premium is directly proportional. If the existing price of the stock increase, the value of the Call options increases as well and vice versa.

• Strike price
Strike price is the price at which the trades are willing to take/give delivery of the underlying security. It is different for different security. The cost of the option increases when the difference between the existing price and strike price is not much and vice versa.

• Expiration period
If the expiration period is higher the cost of the option contract increase. This is because when the trader has more time on hands there are more chances of price fluctuation in a profitable direction.

• Dividends
When the dividend increases the value of the put option increases while the value of the call option decreases.

• Volatility
High volatile stocks yield higher profits hence options highly volatile are expensive as compared to the less volatile ones.

Terms Related to Option Trade

• Strike Price
The predetermined value of the stock at which it will be bought or sold in the future.

• Open Interest
Open interest refers to the total number of option contracts that are currently out there in the market at any given point in time. Open Interest for a contract becomes zero past the expiration date.

• Strike Price Intervals
An option contract can be sold at different strike prices; all these different strike prices are referred to as strike price intervals. These prices are decided by the exchange on which the securities or assets are traded.

• American & European Options
The terms ‘American’ and ‘European’ refer to the two different types of the underlying asset and when the contract is executed. In American options’ the deal can be executed on or before their expiration date. Whereas in the ‘European options’ the deal can be executed only on the expiration date and not before. Indian markets follow European style and hence there is the ‘E’ at the end, CE (Call) and PE (Put).

• Lot Size
The Lot size indicates the set of units of the underlying asset that are part of a single contract. The typical lot size depends on the stock and is determined by the exchange on which the stock is traded.

• Expiration Date
The pre-decided future date on or before which the options contract can be implemented. There are many different durations as set by the exchanges, weekly or monthly.

Advantages of Options Trading

• It is known that buying options is inexpensive initially than purchasing stock. The price of obtaining an option is much lesser as compared to what traders spend to buy shares.

• Option trade allows the investors to freeze the value of their security at a predetermined amount for a specific period. The options contract ensures that one can trade at that predetermined rate any time before the options contract expires.

• Option trade diversifies a trader’s investment portfolio through added income, leverage, and even protection. Options allow hedging against falling stock prices and offer protection against potential losses. Similarly, it also brings extra income to the table.

Disadvantages of trading in Options

• The concept of an Options contract can be complicated for beginners. It can be a misconception of most beginners, and even some experienced investors, who think they can understand trading in options, but the fact is they don't.

• If you hold the options for a longer time its time value decreases due to the concept of time decay.

• There is less standard analytical information on Options contract which can give you hard time while deciding on the type of options contract to buy.

• Options are not available for all stocks which restricts the number of possibilities to yield profit available to you.

This article can be a guide to consider all the factors if you plan to trade options and wish to take advantage of stock price fluctuations.

Read this article to know further on how to trade options.

Also, consider to watch these videos where options are explained from real life examples to make things clearer for beginners.