As we know, options are derivatives whose value is derived from or based on other financial assets. Underlying assets are financial assets upon which a derivative’s price depends on. The most common underlying assets used are stocks, commodities, market indexes, etc.
Let us take an example of stock options to understand how things work. Options and stocks are directly related to each other and vary in the number of shares of a particular stock per contract. For example, there’s an ABC company whose one option contract can be equal to 100 shares and another XYZ company whose one option contract can be equal to 200 shares. Now if you want to buy one call option contract of ABC company it will give you the right to buy 100 shares of that company and if you want to buy one call option contract of XYZ company it will give you the right to buy 200 shares of that company. In options trading we use contract instead of shares, so make sure to not make any mistake during order entries.
Selecting the underlying stock or any other asset can be done by many up to date ways but the two basic ways are fundamental analysis and technical analysis.
1. Fundamental analysis
It is a method of evaluating the intrinsic value of an asset and analyzing the various external and internal factors which could influence the price of an asset in the future. On the basis of affecting factors, fundamental analysis is divided into three categories:-
a) Economic analysis – It basically includes the analysis of general and updated information on GDP, inflation rate, budget, tax rate, etc.
b) Industrial analysis – It includes the analysis of industrial growth rate, technological advancement, product comparisons, etc.
c) Company analysis – It includes the analysis of a company’s income statement, growth rate, etc.
Political factors, inter and intra-country relations are also included in fundamental analysis.
2. Technical analysis
It is a method of predicting the future price movement of an asset by using historical price charts and market statistics. Price charts and market statistics are analyzed by technical indicators such as moving averages, MACD, Bollinger bands, etc. Use of single indicator or combination of multiple indicators on the chart totally depends on individual’s way of analysis.
Fundamental and technical analysis are very different from each other due to their different approaches but to maximize the results one can use the combination of both of them which will ultimately strengthen the trade. At the end of the day, these analyses will only help you in making the decision but the end decision will be yours.