A financial instrument known as a derivative is an agreement between two parties to purchase or sell specific underlying assets at a predetermined future price and time. Derivative contracts primarily fall into four categories: swaps, option contracts, future contracts, and forward contracts. In this post, we’ll discuss option derivatives.
An option contract is a legal agreement in which one party has the right, but not the obligation, to purchase or sell specific securities at a future period, while the other party has both the obligation and the right to do so. There are two different types of options contracts.
1. Call Option: The call option entitles the buyer to purchase the underlying assets at a certain future price. In exchange, the option holder must pay the call option dealer a specific sum of money, referred to as a premium. The buyer of this option is bullish and thinks that the underlying assets' price will increase in the future. For this reason, they acquire the call option, which allows the option buyer to earn infinitely if the value of the underlying option rises.
2. Put Option: The holder of a put option is entitled to sell the underlying assets at a given price within a predetermined window of time. The holder of the put option is pessimistic and believes that the underlying's price will decline. They bought the put option to protect themselves against a decline in price. However, if their assessment is accurate and the price drops, they stand to gain an infinite amount of money.
Hedgers, speculators, and arbitragers are a few of the market participants in option trading.
1. Hedger: A hedger employs option trading to predict an underlying asset that already exists because of an unanticipated shift in its price and to have a more definite result. Stated differently, their aim is to counterbalance any losses resulting from the decline in the value of the current underlying assets.
2. Speculator: Speculators profit from option trading by projecting future price changes and, in accordance with their analysis, assuming a position in a contract. Their only goal is to make money, which is why they engage in advantageous transactions.
3. Arbitrager: These are individuals who purchase from one market, sell to another, and gain profit from the difference in prices in both markets.
The profitability scenarios in options are:
In-the-Money Option (ITM): This option would give a positive cash flow on expiry if it was exercised immediately. When the current market price of the underlying asset is higher than the strike price of a call option or lower than the strike price of a put option, the option is said to be "in the money" (ITM).
At-the-Money Option (ATM): The immediate exercising of this option would result in no cash flow. When the strike price and the spot price of a call or put option are the same, the option is said to be at the money.
Out-of-the-Money Option (OTM): If it is exercised right away, the cash flow is negative. When the strike price exceeds the spot price, a call option is considered out-of-the-money (OTM). When the strike price is exceeded by the spot price, a put option is considered out-of-the-money (OTM).
As we can see, holders of call and put options can benefit indefinitely, but the most loss they can incur is the premium they paid. Conversely, an option trader can lose as much as they like, but their profits are restricted. Because of its versatility, options are a useful tool for income generation, speculating, and hedging. They also aid in price discovery.
When we talk about how options can be used for speculating, hedging, and income creation, we also need to talk about the hazards associated with them. These concerns include liquidity risk, a large initial margin requirement for the seller, trading complexity, time decay, volatility risk, and the potential for significant losses if the option dealer's opinion is incorrect. Option contracts become risky due to these hazards, which also discourage consumers from engaging in option trading.
Hence, option trading entails several risks and offers both infinite profit and limited loss potential for the option buyer and unlimited loss and limited profit potential for the option seller. Therefore, to generate an infinite profit, one must be knowledgeable about the numerous option strategy approaches, be able to effectively manage risk, and ultimately satisfy traders' financial goals through the effective management of the various strategies.