Option trading gives the buyer the right to either purchase or sell the specified security. The buyer (called the holder) of an option is not obliged to execute the transaction. However, when the option is purchased, an upfront payment called premium, is required to be made to the seller. If the buyer opts not to complete the transaction, the premium is forgone. The seller (called the writer) of an option has no choice but to execute the contract. In options trading, the buyer has an option but the seller undertakes an obligation.
Types of Option Trading
Call Option
The buyer acquires the right to purchase the specified security for the contracted price on or before the contracted date. The buyer can call upon the seller to sell him the specified security.
Put Option
A put option vests the buyer with the right to sell the specified security for the agreed price before the agreed date. The buyer can opt to put through the sale for the specified security.
Use of Option Trading
Option trading allows the buyer to trade in the specified security by paying a premium. Such trade may not have been possible in the cash segment on account of trading limits. This is called leveraging of the trading limit.
This mechanism can also be used by the investor to hedge risks of fluctuations in the prices of shares.
