How do options work?

Options are derivatives of an underlying financial instrument like stocks, commodities, and currencies. A good analogy is the curd which is a derivative of milk. So, just like increase or decrease in the price of milk increases or decreases the price of curd, similarly, movements in prices of the underlying instrument affect the price of options.

Options are traded in exchanges MSE, MCX etc., like stocks and commodities. Every option contract mentions its strike price, premium, lot size and expiry date.

• Strike price: The price at which the buyer and the seller of an option have agreed to enter the option contract.
• Premium: The payment made by the buyer to the seller to earn his right to an option contract.
• Expiration day: The last day that the option owner can exercise the right.
• Lot Size: The fixed number of units of the underlying instrument that form part of a single Options contract.

Like any other business transaction, options trading includes buyers and sellers. The buyers of options have rights or a choice and sellers have obligations. The buyers have the choice to exercise his right to buy/sell option before expiry or else opt out and allow the option to expire.

Options are of two types: calls and puts. A Call option gives you the right to buy the option whereas a Put option gives you the right to sell the option.

There is no delivery of options. All transactions are settled in cash.