Types of Options Trading

Types of Options Trading

Options are derivative contracts whose value depends on an underlying asset. It gives the option holder the right to purchase or sell the underlying security at a particular price and date. However, traders do not have the obligation to execute the options contract. So, options emerge as a great investment. There are different types of options. Their features, underlying assets and expiration cycles are the parameters used for their classification. Let’s explore everything about them in the guide.

Understanding Options Trading and Pricing

One needs to understand the intrinsic value and time value of options to understand options pricing. The difference between the strike price and the actual market price of the underlying asset is the intrinsic value of the option. If an option is in the money, it is considered to have a certain intrinsic value.

At times, the market price of the underlying asset may be lower than the strike price. Here, the intrinsic value of a put option is the difference between the strike price and the market price. An option is considered "out-of-the-money" when its intrinsic value is zero. This is because there would be no profit from exercising the option. 

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Table of Content

  1. Understanding Options Trading and Pricing
  2. Features of Options Trading
  3. Types of Options Trading
  4. Types of Options based on Underlying Security
  5. Types of Options based on the Expiration Cycle
  6. Pros and Cons of Options Trading
  7. Cons of Options Trading

Features of Options Trading

Here are the key features of options trading

  1. Option chain: Options are essentially charts that show data of premiums, open or Options Greeks in real-time.
  2. ITM, OTM and ATM:  The profits from options depend on whether they are ITM, OTM, or ATM. If the option holder makes money by exercising the option on its expiration date, it is considered to be in the money (ITM). If executing an option would result in a loss, it is said to be out of the money (OTM). The option is considered to be at the money (ATM) if the profit or loss from exercising the loss is minimal. This may happen if the option contract's strike price is closest to the market price among all the strike prices for an option. 
  3. No obligation to buy or sell: Traders have the option to purchase or sell at the strike price on the expiration day. However, if they want, they can decide not to exercise the option.
  4. Lot size: In the Indian derivatives market, purchasing an options contract for a single unit of the underlying asset is not possible. Rather, you have to purchase a minimum quantity of option contract units. 
  5. Settlement of an option: An option holder may exercise options at the expiration date. In India, a cash settlement system is used. Thus, you are not required to accept the stock's delivery. You receive the profit in your account. 

Types of Options Trading

There are generally two types of options: call option and put option.

Call Option

A call option is essentially a buy option. Purchasing a call option gives a trader the right to buy the underlying assets at the strike price on or before the expiration date. A trader may execute the contract when they expect an increase in the value of the underlying stocks. Traders have to pay a premium to purchase calls. Call options are further divided into two types.

  • Long Call Option: In long call options, the buyer gets the right to purchase the underlying asset at a certain price at a future date. However, it is not compulsory. 
  • Short Call Option: In short call options, the seller agrees to sell the underlying asset to the buyer at a certain price at a future date.

Put option

A put option is a sell option. Purchasing a put option gives a trader the right to sell the underlying security at the strike price on or before the expiration date. Buying a put option is a risk management strategy used by traders to protect themselves from market fluctuations. This is because a put option is usually profitable when the value of the underlying asset drops. Put options lose value if the value of the underlying security increases.

Types of Options based on Underlying Security

Options can have various underlying assets. So, you may find the following types of options based on the underlying securities: 

  • Stock options: Shares of listed companies are the underlying asset of these types of options. They are a popular type of options contracts. 
  • Index options: They have an index of the stock market as the underlying asset. These may include the Sensex, NIFTY50, etc. The performance of the stocks that are a part of a particular index is reflected in these index options.
  • Currency options: They give traders the right to purchase or sell particular currency pairings at a fixed price at a future date.
  • Futures Options: They let the option holders exercise the futures contract. They have futures contracts as their underlying asset. Investors use these kinds of options as a hedge for their futures. 
  • Commodity Options: Here, the underlying assets include commodities like metals, agricultural products, etc. Moreover, they may also include commodity futures. 

Types of Options based on the Expiration Cycle

The options contract expires worthless if the buyers do not exercise it with the expiration date. This has a direct impact on the contracts' time value and pricing. So, it is crucial to purchase or sell options contracts with a suitable expiration date. Options are categorised into the following types based on their expiration cycle:

  • Regular Options: They have standard expiration periods. Four distinct expiration dates are available to investors. Regular options give investors the freedom to select different expiration dates following their objectives and trading strategies. 
  • Weekly Options: Weekly options have the shortest expiration date. They are also referred to as weeklies. These contracts have a one-week expiration date. They must be exercised within that time frame to avoid expiration and losses.
  • Quarterly Options: Their expiration date corresponds to the next quarter. They are also known as quarterlies. Moreover, the expiration dates are predetermined and reduced as per the approaching quarter-end date.
  • Long-Term Options: Long-term options have an expiration period of one to three years. Individuals with extended investment horizons prefer these kinds of options transactions.

Pros and Cons of Options Trading

Let’s now look at the pros and cons of options trading.

Pros of Options Trading - H3

Options trading offers the following benefits:

Low entry cost: Unlike stock transactions, it enables you to open a position with less capital. This is called high leverage. 

Hedging against risks: Purchasing options reduces your risk exposure. The premium you ultimately pay is the maximum amount of risk you may take.

Flexibility: An investor using options can trade according to changes in the value of the underlying security. An investor can employ an options strategy as long as he can predict the direction of the price.

Cons of Options Trading

Here are some of the drawbacks of options trading:

Less liquidity: There are fewer participants in the options market. So, it may take time to find buyers or sellers. So, you may have to pay more for the asset and receive less than other liquid assets.

Risk: An options trader may lose more than the premium. It depends on the specific type of option.  

Complex to trade: Trading options is a bit complex. You have to predict the direction and timing of a certain security's price movement. It can be difficult to get both these things right.

Options are financial contracts that give traders the right to buy or sell assets at a predetermined date and price. However, it is not mandatory to exercise the options. Options are classified into different types. The primary ones include: call and put. However, there are some other types based on their underlying assets and expiration cycles. One can trade options with less capital on a stock trading app. They are useful tools for hedging against market fluctuations. However, trading options are complicated. Moreover, liquidity is a major issue while trading options. So, it's essential to understand the options market before trading.

FAQs on Types of Options

There are primarily two types of options: call and put. However, there are other types depending on their features, underlying assets and expiration cycle.

Correlation shows how much the price movements of two assets are related. It helps in managing risk in a diversified portfolio.

The four options trading strategies include: selling calls and puts, buying calls and puts, spreads and naked calls and puts.

Four popular options strategies are bear put spread, bear ratio spread, bull butterfly spread, and protective put.

The four main types of trading are day trading, swing trading, position trading, and scalping, each differing in time horizon, strategy, and risk tolerance.