What are option contracts or options? Detailed explanation with advantages and disadvantages

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  • January 7, 2024
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It is common knowledge that financial derivative instruments are often characterized by complexity and are surrounded by many fallacies, and this reality unfortunately accompanies even the option contracts that we will discuss today. The number of options contracts that were traded last year amounted to more than 10 billion contracts, and these statistics only cover the American market. This huge number indicates the important position that option contracts have become, especially since it is a flexible financial instrument and provides many solutions for investors to achieve respectable returns. Believe me, you will be lucky to read the article, especially if you are a beginner or looking for the truth about making quick profits from trading in the options market, as deceptive advertisements or some quasi-experts on social media platforms promise.

What are option contracts or options? Detailed explanation with advantages and disadvantages

Our team explained option trading in detail with the advantages and disadvantages to help beginners learn to manage risks and invest safely in the options market while achieving good profits.

What are option contracts? simple explanation

Option contracts are an agreement between two parties, the seller and the buyer, according to which the buyer is given a financial document or future contract that guarantees him the acquisition of the asset in exchange for the strike price on or before the agreed upon date.. Option contracts were first issued in 1973 by the Chicago Board Options Exchange (CBOE), which at that time was limited only to call options. Trading options contracts falls within the scope of financial derivatives, which are primarily included to help investors hedge by reducing risks related to a sudden change in the value of assets. It also provides a suitable opportunity for speculators to achieve good profits, by exploiting changes in the values ​​of the assets from which these contracts are derived. The most important feature that enhances the feasibility of investing in option contracts is that they are binding on the seller who owns the asset, while the investor who holds the contract has the right to abstain or implement according to the extent to which price fluctuation suits his interests. Also, if the contract is terminated by the investor, he only loses the amount of the premium (insurance), which is paid in advance upon concluding the contract.

The most notable disadvantages of option trading are the necessity of activating financial leverage in order to open an options position and the high brokers’ commissions, which may expose you to huge losses if the expectations and strategies used fail. It must also be noted that trading option contracts is not suitable for all investors, because opening an account in one of the professional option contracts trading platforms requires thousands of dollars. For information platform TastyTrade Requires an initial deposit of $2,000, while affiliate TD Ameritrade Requires a deposit of at least $25,000. Also, some may wonder: Are options contracts halal or haram? The short answer is that it is permissible as long as the issuer of the contract owns the commodity, while most scholars tend to prohibit buying contracts from speculators because it is not permissible for a Muslim to sell what he does not own. This explains the absence of the option of trading options contracts from the Saudi Stock Exchange for a period, and it was only listed during the past years after the economic reforms carried out by the Kingdom to enhance its attractiveness as a global financial and economic center.

Advantages

  • Less financial commitment
  • Trading flexibility with less stress
  • The expected returns are unlimited
  • The probability of loss is higher for sellers

Defects

  • Requires large initial capital
  • Brokers’ commissions are high
  • Using margin trading is expensive

Types of option contracts

Option contracts are divided into two types: Call Option and Put Option, which differ mainly according to the direction of price movement.

Call Option

A call option gives the investor the right to buy an asset with the expectation that its value will increase before the time specified for executing the contract. This allows achieving excellent returns from buying the asset at less than its market price at the time of executing the contract, or selling it to speculators in the event that they have a valid contract on an asset that is witnessing an increase and is in great demand.

Put Option

A put option gives the buyer the right to sell, but not the obligation to sell the asset at a specific price, within a time frame starting from the date of purchase until expiration. Put options increase in value as the value of the underlying asset or security declines, while they lose value as the price of the target asset rises. Put Option contracts are usually used for hedging purposes or to speculate on downward price movement.

How to buy option contracts

How do I place option orders? You can start buying and trading option contracts by following the following steps.

  • Opening and activating an account on one of the options trading platforms.
  • Study and analyze the performance of assets to identify the opportunities offered by the market.
  • View the latest option recommendations on specialized groups and websites.
  • Choose the target stock or commodity.
  • Predict the execution price and determine the appropriate time frame to activate the contract.
Explanation of buying and trading option contracts

The most prominent questions about option contracts

In this paragraph, we will try to answer most of the questions asked by beginners, which will enable you to decipher the mystery and learn to trade option contracts in a sound way.

What are the differences between options contracts and binary options?

Options differ from binary options because they are a contract concluded for the right to purchase assets between two parties according to conditions, while binary options are bets on the direction of price movement over a period of time ranging from 60 seconds to a few minutes at the maximum. If you are interested in it, you can check out this guide about Best binary options trading companies, which will enable you to get to know each platform closely. For reference, Binary Option platforms do not require large investments. An initial capital of approximately $500 to $1000 is sufficient to try the market. Also the time domain for execution Binary options contracts It is small, not exceeding 5 minutes, and therefore luck may also control the course of the bet to some extent.

How do I calculate my profit and loss in option contracts?

Trading options contracts is very profitable, but at the same time it involves bearing high risks compared to other financial derivatives. The size of the profit from trading option contracts is unlimited and can reach more than 50 times, for example, but the size of the maximum losses is limited to the value of the premium (insurance amount) and the commission that is paid to the broker in order to execute the contract. Remember that you will often use margin trading to reach the limit required to open an options contract position, so the size of profits or losses must be doubled according to the value of the leverage used. By the way, the leverage ceiling available on options platforms is lower compared to most Professional Forex trading companiesHowever, this does not mean reducing its impact on the final results, whether positive or negative.

What is the difference between American and European options?

Simply put, American options contracts can be executed at any time between the time of purchase and the expiration date, while European options are only binding at the contract expiration date. This reality means the flexibility of trading American option contracts compared to European options, which also explains the high premium with its concentration in the stock market, which witnesses more rapid price fluctuations.

Conclusion

According to my personal experience with trading option contracts, I believe that it is a high-risk investment mechanism despite the huge profits if the correct forecast is chosen. The latter requires market study and technical analysis, which can only be achieved with a lot of experimentation and accumulation of experience. I hope that my brief article is sufficient to adequately explain the field of options, and we are also ready to answer any additional questions in the comments section. Finally, you can support the website team by sharing the article on social media. We also invite you to browse the rest of the articles listed in the investment section for more information about financial instruments and to acquire more skills related to studying financial markets.

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