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Basics Of Options

Understand Options

What are option contracts?

In futures contracts, theoretically there is a possibility of unlimited profit and unlimited loss. If  you trade in Futures contract, you have an obligation to bear that loss or gain profits as the case may be, depending on the spot price on expiry.

 

If you enter into a contract to buy or sell an asset at a particular price, on expiry you have the obligation to fulfil it, irrespective of the current market price. Right? 

 

Now what happens if you have a choice? Or right? If a derivative contract can give you choice or right, a right to enter into the contract or simply back out at a later stage. What if  you don’t have an obligation to fulfil the contract?

 

Do you think the choice or right is available? The answer is YES!

 

This choice is called OPTION, a type of derivative contract that gives you a CHOICE.

 

Choice to buy or sell. Choice between Right and Obligation.

 

  • When you chose right – you are the buyer of that choice
  • When you choose an obligation – you are the seller of that choice.
  • When your choice is to buy – it is called a call option
  • When your choice is to sell – it is called a put option.

Let me decode this for you with the help of an example.

 

Assume Saksham is bullish on a stock. It is trading at ₹670/- today. He has the right today to buy the same stock one month later, at say ₹ 750/-.

 

Now If the share price on that day is more than ₹750? He would buy it. It means that after 1 month even if the share is trading at ₹850, Saksham can still get to buy it at ₹750! In order to get this right, he is required to pay a small amount today, say ₹50/-.

 

If the stock price moves above ₹750, he can exercise his right and buy the shares at ₹750/-. If the share price stays at or below ₹750/- he does not exercise his right and he does not need to buy the shares. 

 

Saksham has to lose ₹50/- in this case. An arrangement of this sort is an Option Contract.

 

After Saksham gets into this agreement, there are only three possibilities which can occur.

 

1. The stock price can increase, - say ₹850/-


2. The stock price can fall - say ₹650/-


3. The stock price can remain same at ₹750/-

 

Case 1: If the stock price goes up, then it would make sense in exercising his right to buy the stock at ₹750/-.

 

The profit and loss would look like this –

 

Price at which stock is bought = ₹750

 

Premium paid = ₹50

 

So total Expense incurred = ₹800

 

Current Market Price = ₹850

 

Profit = 850 – 800 = ₹50/-

 

Case 2 – If the stock price goes down to say ₹650/- obviously it does not make sense to buy it at ₹750/- as effectively he would be spending ₹800/- (750+50) for a stock that’s available at ₹650/- in the open market.

 

In this case, he will incur a loss of  ₹50 only (premium paid).

 

Case 3 – Likewise if the stock stays flat at ₹750/- it simply means he is spending ₹800/- to buy a stock which is available at ₹750/-, hence he would not invoke his right to buy the stock at ₹750/.

 

In this case, he will incur a loss of  ₹50 only (premium paid).

 

Let us dig more into this example and answer a few questions with logic.

 

Why did Saksham enter into this contract even though he knows that he might lose ₹50 if the stock price does not increase or stay flat?

 

  • Saksham would lose ₹50, but the best part is that he knows that, this is his maximum loss before hand. Hence there are no negative surprises for him. Also, as and when the stock prices increase, so would his profits.
  • Under what circumstances does Saksham's trade make sense? - Only when the price of the stock increases.
  • Under what circumstances would the seller of the contract’s position make sense - Only that scenario when the price of the stock decreases or stays flat.

So Why do you think the other party or the seller is taking such a big risk? He would lose a lot of money if the stock prices increase after one month.

Well, think about it. There are only three possible scenarios, out of which two benefit the seller.

 

Statistically, the seller has 66.66% chances of winning the bet as opposed to Saksham’s 33.33% chance.

 

Let us summarize a few important points now –

 

  • The payment from Saksham to Seller ensures that Saksham has a right (remember only he can call off the deal) and Seller has an obligation (if the situation demands, he has to honour Saksham’s claim). Saksham is an option buyer and Seller of the contract is the option seller. 
  • The outcome of the agreement at termination (end of 1 month) is determined by the price of the stock. Without the stock, the agreement has no value. The Stock is therefore called an underlying and the agreement is called a derivative. An agreement of this sort is called an “Options Agreement
  • The agreement is entered after the exchange of ₹50, and this is the price of this option agreement. This is also called the “Premium” amount.
  • Every variable in the agreement –Stock, Price and the date of Execution is fixed.
  • As a thumb rule, in an options agreement the buyer always has a right and the seller has an obligation.

 

What is long on option? 

Buyer of an option is said to be “long on option”. As we have discussed earlier, he/she would have a right and no obligation with regard to buying/ selling the underlying asset in the contract. So basically, when you are long on equity option contract: 

 

  • You have the right to exercise that option. 
  • Your potential loss is limited to the premium amount you paid for buying the option. 
  • Profit would depend on the level of underlying asset price at the time of exercise/expiry of the contract. 

What is short on option?

Seller of an option is said to be “short on option”, he/she would have obligation but no right with regard to selling/buying the underlying asset in the contract. When you are short (i.e., the writer of) an equity option contract: 

 

  • You have the obligation to fulfil the contract.
  • Your loss is not limited. It depends on the price of the underlying asset.
  • Your maximum profit is limited to the premium received.

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