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Types of contract in Options Trading

Updated: Apr 8, 2021

Welcome to yet another article regarding Futures and Options trading. In the previous article, we had covered comprehensively all the terms related to futures and options. We had seen that there are two types of options in the derivative market. One is the call option and the other is the put option.

You can be either a buyer or seller of these options. Based on what you select to do, the profit and loss amount changes. Of course, we will get into the profit and loss figure at a much later stage of our article. We had learned about the call and put option. We had learned what “The Call Option” means. We had taken a few examples about how the call and put options work.

Let's start with the contracts. So, let me first introduce to you what we're going to cover in this article. We're going to understand about types of contracts, the expiry of contracts, what are the types of settlement and what are the type of assignments?

The first topic is the type of contract. Before that, let me tell you one thing. For every trading, you buy something and you sell something. Like if you are supposed to open a stationery shop, then you buy stationery and you sell stationery. Even somebody's opening a vegetable shop, what they are doing? They are buying vegetable seeds and selling vegetable seeds.

We are selling contracts. So, as I told you in the earlier article that options are a special contract in which the buyer gets the special right to execute and to assign the contract if it is favorable and profitable to him and he can leave the contract if it is not profitable to him. One way contract beneficial to the buyer but for that benefit or that right, the buyer has to pay a premium. So, you understand the basic commodities which are bought and sold is a contract.

There are three types of options contracts. Near, next, and far month contracts. Mostly, people do trade in the near month of the contracts because the liquidity is very high. If this month is April, it means April is the near-month contract. May will be the next month's contract and June will be the far month contract.

The far month time of contracts is illiquid and have very few people trading them. Some broker does not allow to trade in the far month type of contract. If they allow consumers to trade in these, and the market progress against the consumer’s positions, there is a high chance that there will not be any counterparty for the consumer to exit his loss-making position. Due to this, the consumer will be forced to bring in additional margins to compose for these losses, and if the consumer defaults on this, as per regulations the accountability will be on the broker.

Additionally, since these contracts are illiquid, if a person places a market order, the contract price moves exceptionally, with no actual movement in the underlying/spot price. This again has regulatory involvement for the broker.

Since stockbrokers have every right to take compulsory steps to block any contract if they recognize high risk in allowing that contract to trade at any point in time, they just have disallowed trading in the far month contracts and allowed it only in definite scrips.

BANK NIFTY futures contracts have the highest of the 3-month trading cycle. The near-month contracts (one), the next month contracts (two), and the far month contracts (three). A new contract is initiated on the trading day following the expiry of the near-month contract. The new contract will be initiated for a three-month duration. This way, at any point in time, there will be 3 contracts accessible for trading in the market i.e., one near month, one mid-month, and one far month duration.

BANKNIFTY futures contracts will expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday in India, the contracts expire on the previous trading day of that month.

All futures and options contracts are money settled or through delivery settled, for example through the trading of money. The underlying asset for the index futures and options of the Nifty can't be conveyed. These contracts, subsequently, must be gotten comfortable money. Futures and Options on singular securities can be conveyed as in the market price. Nonetheless, it has been as of now commanded that the investment in futures and options would likewise be money settled. The settlement sum for a cash market is gotten across the entirety of their customers, regarding their commitments on the mark to market, premium, and exercise settlement.

An Assignment is just contrasting to an Exercise in Options. In the Assignment of the option contract, the buyer or seller of the option contract exercises his right to buy or sell. When an Option is exercised, the stock exchange uses a trading software to accidental select a seller or buyer to honour the contract.

Assume you have sold Reliance 1600 call with premium received of Rs 15. The price of Reliance stocks moves up to Rs 1700. In such a case, it is possible that some trader who has bought Reliance 1600 call would choose to exercise his Option. And, if you are assigned by the software to honour the contract then you have to bear the loss of Rs 100 - Rs 15 = Rs 85 and honour the contract.

Only a little part of Options traded is assigned. All option holders have the right to exercise their options whatever of the profitability or loss in the trade.

In conclusion of this article, I would like to tell you that we had covered the types of contract, types of assignment and settlement type. In short, the option buyer welfare only if the price of the asset increases higher than the strike price and at the time of agreement the option buyer give a certain amount to the option seller, that is called the premium amount.

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