There are numerous ways for trading and investing in the financial markets. Each of these methods has its own advantages and disadvantages, but the final aim of all of them is to maximize the profit and minimize the loss in the trades and investments. Option contracts are one of the methods professional traders and investors frequently use. In this article, we will explain what an option contract is, go through its different types and functions, and clarify how to trade it. Stay with.
What are option contracts?
An option contract is a contract that lets the trader sell or buy an asset at a specific point of time in the future, and at a predetermined price. These contracts have two types: buy or “call”, and sell or “put”. If you tend to trade an option contract, you have to buy one of these two types.
The call option lets the trader buy an asset at a predetermined price in the future. Traders usually buy call options when they feel the price of an asset is going to increase. The put option lets the trader sell an asset at a predetermined price in the future. Traders buy put options when they assume the price of an asset is going to decrease.
You may think that option contracts are very similar to future contracts. The truth is that these two contracts are so similar, but one big difference exists between them: the future contracts necessitate the traders to execute the contracts at the price they have determined, but the option contracts don’t have this necessity. Holders of option contracts are free to execute them, or to ignore them.
Components of option contracts
An option contract has 4 components:
- Size: the size of the asset you are going to trade. For example: 1 bitcoin or 1,000 dollars.
- Expiration date: the date at which the contract expires, and its holder can’t execute it anymore.
- Strike price: the predetermined price at which the asset will be bought or sold.
- Premium: the current market price of the contract itself, or the amount the buyer of a contract must pay to its writer.
An example to clarify option contracts
Alice is a bitcoin trader. The current price of bitcoin is $20,000, but Alice predicts the price of bitcoin will increase to $24,000 in the next few months. Alice can now go to a cryptocurrency exchange and buy 1 bitcoin at the current price, but the problem is that she is not sure about the accuracy of her prediction. Therefore, she decides to buy a call option with the following features:
- Size: 1 bitcoin
- Expiration date: two months later
- Strike price: $23,000
- Premium: $400
Alice pays 400 dollars and buys an option contract. Two months later, if the price of bitcoin reaches $24,000, Alice can sell her option contract at $23,000. Considering the $400 she had paid for the contract, now her profit equals $600. On the other hand, if the price of bitcoin doesn’t increase, or even decrease, she can decide not to execute her contract. This way, her loss equals $400, and not thousands of dollars.
American and European option contracts
There are two other categories of option contracts, namely American and European option contracts. American option contracts let their holders execute their contracts at any desired time before the expiration date. European option contracts, on the other hand, can only get executed at the expiration date. Pay attention that these two contracts are not limited to any specific jurisdiction. You can buy these two types of contracts in any country or within any jurisdiction.
Advantages and disadvantages of option contracts
As we previously mentioned, option contracts have their own pros and cons. Some of the advantages of these contracts include:
- Being a good hedge against market risks
- Being more flexible in risky trades
- Letting users combine different strategies in a single trade
- Being used in both bullish and bearish markets If we want to name a number of disadvantages, we can refer to:
- The intrinsic complexity of option contracts
- The potential risks for contract writers
- Low level of liquidity
Option contracts, as their names suggest, let the traders buy or sell an asset at a predetermined price in the future. They have an expiration date, and you as the holder of these contracts can decide to execute or ignore them when the time reaches. We also referred to intrinsic complexity as one of the drawbacks of these contracts. If you still wish to experience using these contracts in spite of all complexities, you must take help from cryptocurrency exchanges that offer these contracts.