WHAT IS AN OPTION CONTRACT?

In the previous post, Team HoldingB helped you understand about Smart Contract, right?! Today, we will learn about Option Contract!!!

Definition of an Options ConTract

An options contract (or Option) is a type of derivative, a derivative contract which is simply an agreement between two parties to facilitate a potential transaction on the underlying asset (stocks, bonds, crypto-assets) at a specific price that is set from the start, referred to as the strike price, before the expiration date. An options contract gives the buyer or the holder the right but not the obligation to either buy or sell the underlying asset at the strike price within a given period. There are two types of options, call options and put options. In a few words, the right to buy is the call option, and the right to sell is the put option

Why do we Use Option contracts?

Option Contracts can be used for four main purposes:

HEDGING / RISK MANAGEMENT

Buying an SPX put option would give the investor some downside protection.

Options are a fantastic tool for hedging exposure to a certain asset. Let’s say an investor has a portfolio of S&P 500 stocks and is concerned about a drop in their value over the next few months.

If the S&P500 falls, the value of the investors stock portfolio will drop, but he will have made some profits from the bought put which will help offset the losses.

This is a simple example and there are many different ways in which options can be used for hedging and risk management.

LEVERAGE

Since options cost only a small fraction of the price of the underlying asset an investor can gain a larger exposure to a certain security by buying put or call options instead of buying the underlying asset directly.

This particular feature of options is known as leverage.

Let’s say you want to invest in ABC Corporation stock, as you think the price of its shares will go up over the next 3 months. If you have $1,000 and the shares cost $50 you could only buy 20 shares.

Instead, you could buy 2 call option contracts for $500 that give you the right to buy 100 ABC Corporation shares at $50, 3 months from now.

If the price of ABC’s shares goes up to $60 you will earn a 20% return if you invested in the shares directly.

At expiry, the $50 call option would be worth $10 with the underlying stock trading at $50. In this case, the call option has achieved a 100% return.

However, leverage cuts both ways and if the stock doesn’t move as expected, the investor could lose 100% of their investment.

INCOME

Using options to generate income is a popular strategy with investors. Covered calls are a logical place for stock investors to start because it is an easy scenario to understand.

Investors who sell call options on shares they own, can produce an income in addition to any dividends earned.

By selling a call option, the investor gets to keep the option premium, but there is a possibility that the shares will get called away if the stock price rises above the strike price of the sold call.

Covered calls will be covered in more detail shortly.

Other investors will use options to generate income on shares they have no ownership of via more advanced strategies such as vertical spreads, iron condors, calendar spreads and butterflies.

SPECULATION

Many investors and traders will use options to speculate on the market. Those expecting the market to rise might buy call options in the hope of making a large potential return.

Those expecting the market to drop might buy put options.

Other traders may opt for income generating strategies.

The great thing about options is that there are many strategies that can be used, no matter what your market outlook or opinion

Types of Options Contracts

There are two types of options contracts: puts and calls. Both can be purchased to speculate on the direction of the security or hedge exposure. They can also be sold to generate income.

In general, call options can be purchased as a leveraged bet on the appreciation of a stock or index, while put options are purchased to profit from price declines. The buyer of a call option has the right, but not the obligation, to buy the number of shares covered in the contract at the strike price. Put buyers, on the other hand, have the right, but not the obligation, to sell the shares at the strike price specified in the contract.

Option sellers, also known as writers, are obligated to transact their side of the trade if a buyer decides to execute a call option to buy the underlying security or execute a put option to sell.

Call Options: If you are bullish on a crypto asset, for example, expecting prices to increase, then you should buy a call option. In this arrangement, you exercise your option by buying at the strike price if prices are higher. Generally, traders buy a call option if they are confident about the crypto asset’s future, and they believe that the price will increase before the expiration date. In a call option transaction, a position is opened when a contract or contracts are purchased from the seller, also referred to as a writer. In the transaction, the seller is paid a premium to assume the obligation of selling shares at the strike price

Put Options: If you are bearish on a crypto asset, for example, expecting prices to fall in the future, then you can bet on the future price decrease by buying a put option. In this arrangement, you exercise the put option if prices are lower than the strike price.

Two important notes here:

The contract can be settled directly in cash instead of having to buy the underlying asset and sell it and do all this procedure.
Not all options are the same. There are American and European options. You can exercise American options at any point in their lifetime, from the moment you buy till the expiration date. On the other hand, European options can only be exercised on the expiration date and not before, but they can be traded at any time.

Benefits of an Options Contract

Leverage: Options allow you to employ considerable leverage. This is an advantage to disciplined traders who know how to use leverage.
Risk/reward ration: Some strategies, like buying options, allows you to have unlimited upside with limited downside.
Unique Strategies: Options allow you to create unique strategies to take advantage of different characteristics of the market – like volatility and time decay.
Low capital requirements: Options allow you to take a position with very low capital requirements. Someone can do a lot in the options market with $1,000 but not so much with $1,000 in the stock market.

Foible of an Options Contract

Lower liquidity: Many individual stock options don’t have much volume at all. The fact that each optionable stock will have options trading at different strike prices and expirations means that the particular option you are trading will be very low volume unless it is one of the most popular stocks or stock indexes. This lower liquidity won’t matter much to a small trader that is trading just 10 contracts though.
Higher spreads: Options tend to have higher spreads because of the lack of liquidity. This means it will cost you more in indirect costs when doing an option trade because you will be giving up the spread when you trade.
Higher commissions: Options trades will cost you more in commission per dollar invested. These commissions may be even higher for spreads where you have to pay commissions for both sides of the spread.
Complicated: Options are very complicated to beginners. Most beginners, and even some advanced investors, think they understand them when they don’t.
Time Decay: When buying options you lose the time value of the options as you hold them. There are no exceptions to this rule.
Less information: Options can be a pain when it is harder to get quotes or other standard analytical information like the implied volatility.
Options not available for all stocks: Although options are available on a good number of stocks, this still limits the number of possibilities available to you.

How To Trade Crypto Options Contracts?

Trading options on Binance is an easy process — All you need is to download the Binance app. Once done, you will need to activate your futures account and click on the Trades tab to choose “Options.”

Ensure to fund your future wallet. You can do that by transferring funds from your spot wallet to your future account.

For options, you can choose different periods, such as 10-minute, 30, 1 hour, 8, and 1 day. These periods represent the expiration date of your trade.

Remember you have the put and call option, where call deals with an increase in anticipation, while put deals with a decrease. You can choose either of the two based on your preference and analysis.

Input the contract size

When you’re done, click to “buy call”, after which the premium will be deducted in USDT from your future wallet.

You can use the “Positions” tab to monitor your open positions. It will also reflect the amount of time you have before the expiry time. So, suppose you want out, you can click to settle and close the position

See ya in the next article !

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