Basics of Derivatives
Till now, we have completed our discussion on ‘Futures.’ Starting from this section we will learn about a new derivative instrument called ‘Options’.
Options are very interesting and versatile derivative instruments. So far, we have learned about forwards and futures. We learned that futures overcome limitations of forwards. However, in futures, theoretically there is a possibility of unlimited profit as well as loss. In Future contract the trader has an obligation to bear that loss or enjoy profits as the case may be on expiry.
Now, what happens if the trader has a choice? If a derivative contract can give the trader a choice to enter into the contract or simply back out at a later stage. Suppose the trader doesn't want to enter into an obligation to fulfil the contract. If so, then the trader can exercise choice as per the situation. If the situation is in his/her favour, he can exercise the right and go ahead with the contract and take the risk as per his/her risk appetite. Else can back out and let the contract be!
Do you think this kind of choice is available? yes
This choice is called OPTION, a type of derivative contract that gives you a CHOICE.
Choice of right to buy or sell the asset, at a pre-determined price and time.
Now think about it - if in a contract, 1 party has a choice or right to enter or not enter the contract as per the situation, the other party has to take an obligation.
There are few important features of an option contract.
- When you choose to take up the right – you are the buyer of that choice or option.
- When you choose to take obligation – you are the seller of that choice or option. So, this choice can be bought or sold.
- Now choose what to do?
- When your choice is to buy the asset – it’s called a 'Call' option.
- When your choice is to sell the asset – it is called a 'Put' option.
We will learn more about Call and Put options in the subsequent sections of this module.