Understanding derivatives can be a daunting task, especially for those who are just starting to get their feet wet in the world of finance. This comprehensive guide will provide an introduction to options derivatives and explain how they work, making the process easier to understand. With this guide, you will be able to make informed decisions regarding potential investments in these instruments.
What are Options Derivatives?
Options derivatives are financial instruments that give their buyers the right, but not the obligation, to buy or sell the underlying asset at a predetermined price and date. These instruments are traded on exchanges and are used for hedging, arbitrage, and speculation. Options derivatives can be used to gain exposure to the market without investing in the underlying asset.
Types of Options Derivatives
Call Options
Call options are contracts that give the buyer the right, but not the obligation, to buy the underlying asset at the predetermined price and date. This type of option is used when the investor believes that the price of the underlying asset will increase.
Put Options
Put options are contracts that give the buyer the right, but not the obligation, to sell the underlying asset at the predetermined price and date. This type of option is used when the investor believes that the price of the underlying asset will decrease.
Exchange Traded Options
Exchange-traded options are contracts traded on exchanges and are standardized in terms of the underlying asset, expiration date, and strike price. These contracts are traded between buyers and sellers, and the exchange acts as the intermediary.
How do Options Derivatives Work?
Exercising the Option
The buyer of the option has the right, but not the obligation, to exercise the option and buy or sell the underlying asset. If the option is in-the-money at expiration, the buyer will exercise the option and receive the underlying asset. If the option is out of the money at expiration, the buyer will not exercise the option and will not receive the underlying asset.
Payoff Diagrams
A payoff diagram is a visual representation of the profit/loss of an option at expiration. It is used to understand the possible outcomes of the option and the potential profit/loss.
Option Pricing and Profit/Loss
The price of an option is determined by several factors, including the underlying asset’s price, volatility, time to expiration, and strike price. The profit/loss of an option is determined by the difference between the option’s strike price and its expiration price. If the option is in-the-money at expiration, the buyer will make a profit; if it is out of the money at expiration, the buyer will incur a loss.
Risks Involved with Options Derivatives
Options derivatives are highly speculative instruments and involve a high degree of risk. If the underlying asset moves in the opposite direction of what the investor has predicted, the investor could incur a significant loss. Additionally, options derivatives have an expiration date, so the investor must be aware of when the option will expire and must be prepared to take action accordingly.
Conclusion
Lastly, options derivatives are leveraged instruments in future and option trading, meaning that the investor can control a large amount of the underlying asset with a relatively small amount of capital. This can provide a significant amount of leverage, but it also increases the risk of loss.
