Hamed Tavakoli
An options contract is a contract in which the trader has the discretion to execute the trade based on the conditions of the agreement. This means the trader can choose whether or not to buy or sell on the contract date. The conditions of the trade specify that the price of the asset being traded is predetermined, and the transaction can occur either on or before a specified date.
Options contracts fall under the category of derivative markets, where investors can profit by predicting the future price of any asset. Experienced traders typically select this type of contract to manage the risk of their open positions.
What are the types of trading contracts?
Trading contracts can be divided into five categories:
- Options Contract
- Futures Contract
- Hedging Contract
- Financial Services Contract
- Swap Contract
What are the characteristics of trading contracts?
In futures contracts, both parties agree to trade a specified asset at a predetermined price on a future date. Options contracts work similarly to futures contracts, with slight differences. The assets traded include currencies or commodities, and the transaction is completed once the mentioned money or goods are received. The advantage of this type of contract is the high leverage it offers to traders.
In hedging contracts, the investor uses two investment portfolios. Part of the investment is placed in one portfolio while another portion is simultaneously invested in a different portfolio. There must be an inverse relationship between the two so that the growth of one causes the decline of the other. Thus, if the trader incurs a loss in one project, it can be compensated by the profit from the other portfolio.
A financial services contract is concluded between an individual and a financial advisor. In this type of contract, the advisor can provide existing solutions at their discretion or directly manage the investor’s capital. The second scenario involves an investment management contract where the financial advisor manages the individual’s investments in the stock market, real estate, industrial shares, etc., based on the contract type.
In a swap contract, the parties mutually exchange a set of cash flows from a futures contract. In a swap contract, one party makes payments based on a random variable, such as exchange rates or interest rates. This type of payment is called a variable or floating payment. The other party to the agreement pays a fixed amount or sometimes a floating amount based on another variable. In this transaction, both parties are referred to as payers, who can be variable-rate payers or fixed-rate payers.
What are the features of options contracts?
Options contracts come in two main types: Call options and Put options. When a trader believes the price of the asset being traded will increase, they buy a call option. If they predict that the price of the asset will decrease, they use a put option.
There are two methods to execute options contracts. In one method, the contract is executed before the specified expiration date. In the other method, known as the European option, the contract is only executed on the expiration date. Additionally, the contract holder has the right to sell the agreement to another person before the expiration date.
The four main components of an options contract are quantity, expiration date, strike price, and the options premium. Quantity refers to the number of contracts through which the trade will be executed. The expiration date is the date on which the contract will be executed, and after this date, the contract is no longer valid, and the investor cannot make any changes to the trade. The trade for buying or selling the desired asset on or before the expiration date occurs at the strike price. The amount the investor pays to set up the contract and the right to choose whether to execute the contract on a specified date is called the options premium. The premium amount continually changes until the expiration date.
What are the steps of an options contract?
The steps for executing an options contract for trading cryptocurrency are as follows:
First, the seller creates an options contract at a specified time with the subject of selling or buying. Then, the contract is listed on a crypto exchange that allows options trading. Sometimes, the buyer might register an options contract on the exchange and wait for a seller. Now, if the strike price is lower than the current price of the desired cryptocurrency, the trader can reduce the options premium, execute the contract, and make a profit. Conversely, if the strike price is higher than the current price of the cryptocurrency, the trader can choose not to execute the contract. In this case, although the trader loses the options premium, they avoid buying the cryptocurrency at a higher price, thus preventing a greater loss.
How does an options contract work?
To better understand how options contracts work, let’s consider a practical example. Suppose the price of each Bitcoin unit is $53,000 on May 1st. The trader predicts that the price of Bitcoin will increase by the end of July. They decide to buy 10 European-style options contracts with a strike price of $55,000 and an options premium of 0.0004 Bitcoin per contract. The expiration date of this contract is July 28th. Since the price of each BTC was $53,000 at the time of contract purchase, the premium for each contract equals 0.0004 times $53,000, which is $212. The trader bought 10 contracts, so the total price will be $2,120. According to the contract, the trader can buy 0.1 Bitcoin at the strike price of $55,000 on the expiration date.
In other words, at the end of July, the holder of the options contracts can use their 10 contracts to buy one Bitcoin for $55,000. Let’s assume the expiration date arrives on July 28th, and two scenarios can occur:
In the first scenario, Bitcoin has increased in price to $60,000. By executing the contract, the trader makes a profit of $5,000 (the difference between $55,000 and $60,000). After deducting the options premium for the ten contracts ($2,120), the net profit is $2,880.
In the second scenario, if Bitcoin has decreased in price to $50,000, executing the contract would result in a significant loss for the trader, so it is better not to execute the contract. In this case, they only lose the premium amount of $2,120, and the contract expires.
Read More: How to Trade Stocks: Six Steps to Start
