When most of you think of investment in stock market, you think of buying stocks and holding on to them with a view to making long term gains, which is also one of the more common investment strategies. It’s also a perfectly sensible way to invest, providing you have some idea about which stocks you should be buying. But many of you are probably completely
Before going to explain options in detail, let?s go through an example that make you the basic concept clearer. Ramesh has a commercial shop and as he is in need of some cash he want to sell his commercial shop which has a current value of Rs.10, 00,000. Praveen has some news that within few months there is a proposal that a shopping mall will be going to build in front of the commercial shop and if that will happen the value of the shop will appreciate, but this is only news at this time. For this reason Praveen does not want to invest full money right now in this uncertain situation, but at the same time, he also doesn?t want to let it go such an opportunity to invest and make money. ?Now Praveen has found a way out asked Ramesh to agree upon a contract to buy his shop at a future date. Ramesh also agreed up on the proposal.
As per this contract agreement
- Praveen Pays a non-refundable upfront agreement fee of Rs.2, 00,000 to Ramesh and Ramesh is binding by the contract to lock the shop for sale to Praveen after six month from now.
- Ramesh has fixed the sale price of the shop after six months at the current price of Rs. 10, 00,000 that means he has the obligation to sell the shop at the current price irrespective of whatever the value of the shop after six months
- After six month Praveen may or may not buy the Shop as per his decision, and Ramesh has no right to object as he is receiving Rs.2, 00,000 upfront from Praveen.
Now after having the agreement, both have to wait for six months. The value of shop after six months obviously dependent upon the factor that ?Shopping Mall? is going to build in front of the shop or its just was a rumor.? Irrespective of the factor there are only three possible outcomes-
- If the Shopping Mall plan is approved as expected, than the price of the shop goes up, let?s say it shoots up to Rs.15,00,000/-
- The Shopping mall plan does not come up, it was only a rumor and real-estate market crashes , the shop price collapses, say to Rs.7,00,000/-
- Nothing happens, price stays flat at Rs.10,00,000/-
Now after six month let?s see what should Praveen do in the above three scenario
Scenario 1: Price goes up to Rs.15, 00,000/-
Since the shopping mall project has come up as per Praveen?s expectation, the shop price has also increased. As per the agreement, Praveen has the right to buy the shop at the end of 6 months with the agreed price of Rs.10, 00,000/-. Now, Praveen should have act upon the deal by buying the shop as the deal is in favor ?
We can calculate how much money Praveen is making by buying the shop-
His total cost = Rs.2, 00,000/- (agreement fee) + Rs.10, 00,000 (shop price agreed) = Rs.12, 00,000/-
His profit = Rs.15, 00,000/-(current value of shop he can get by selling) ? Rs.12, 00,000/- (total cost) =???? Rs.3, 00,000/-
Scenario 2: Price goes down to Rs.7, 00,000/-
Since the shop price has decreased. As per the agreement, Praveen has the right to say no to buy the shop at the end of 6 months with the agreed price of Rs.10, 00,000/-. Now, Praveen should refrain from act upon the deal, and say no to by the shop as the deal is not in his favor ?
We can calculate how much money Praveen is losing by buying the shop-
His total cost = Rs.2, 00,000/- (agreement fee paid) + Rs.10, 00,000 (shop price agreed) = Rs.12, 00,000/-
His loss if he buy the shop = Rs.7, 00,000/-(current value of shop he can get by selling) ? Rs.12, 00,000/- (total cost) =???? Rs.3, 00,000/-
His loss if he does not buy the shop = Rs.2, 00,000/-(agreement price paid)
So it is better not to buy the shop and let it go the agreement price in the pocket of Ramesh.
Scenario 3: Price stays at Rs.10, 00,000/-
Since the shop price remained same as before, Praveen will obviously walk away from the deal and would not buy the shop as the deal is not in his favor ?
We can calculate how much money Praveen is losing by buying the shop-
His total cost = Rs.2, 00,000/- (agreement fee paid) + Rs.10, 00,000 (shop price agreed) = Rs.12, 00,000/-
His loss if he buy the shop = Rs.10, 00,000/-(current value of shop he can get by selling) ? Rs.12, 00,000/- (total cost) =???? Rs.2, 00,000/-
His loss if he does not buy the shop = Rs.2, 00,000/-(agreement price paid)
So it is better not to buy the shop and let it go the agreement price in the pocket of Ramesh.
In the above example, the agreement has specifically given Praveen (the buyer) an option to buy or let it go without buying after six months by paying an upfront contract fee. Praveen has a right and may or may not buy depending upon the valuation of the shop after six month and Ramesh (the seller) is bound to sell the shop at the agreed price, if Praveen wants to buy it. This agreement is typical concept of a Call Option that we will discuss later in this article.
So what is an Option!
An ?Option? is a type of security traded on stock exchanges that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options are a type of derivative product.
There are two types of options – call and put. When you buy a call option, you have the right but not the obligation to purchase a stock or index at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock or index at the strike price any time before the expiration date.
The right to buy is called the ?Call Option?, while the right to sell a security is called a ?Put Option?.
Options minimize risks for buyers by setting a pre-determined future price for an underlying asset, without the obligation to buy in a future period.
The seller of an options contract is called the ?options writer?. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer.
There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed.
Here are some Options-related jargons you should know about-
Premium: The upfront payment made by the buyer to the seller to enjoy the privileges of an option contract. In our above stated example you can take Rs.2, 00,000/- upfront agreement fee paid by Praveen to Ramesh as ?Premium?.
Strike Price / Exercise Price: The pre-decided price at which the asset can be bought or sold. In the example you can take as Rs.10, 00,000/- to be paid as shop price after 6 months is ?Strike Price?.
Strike Price Intervals: These are the different strike prices at which an options contract can be traded. These are determined by the exchange on which the assets are traded.
Underlying Price: A derivative contract derives its value from an underlying asset (for example the shop price in our example is considered an underlying asset that changes it values over time). The underlying price is the price at which the underlying asset trades in the spot market. Stock price or Index value is the underlying asset price in case of you are trading stock options or index options.
Expiration Date: A future date on or before which the options contract can be executed. Options contracts have three different durations you can pick from:
- Near month (1 month)
- Middle Month (2 months)
- Far Month (3 months)
*Note: Long terms options are available for Nifty index. Futures & Options contracts typically expire on the last Thursday of the respective months, post which they are considered void.
Lot Size: Lot size refers to a fixed number of units of the underlying asset that form part of a single F&O contract. The standard lot size is different for each stock and is decided by the exchange on which the stock is traded. E.g. options contracts for Reliance Industries have a lot size of 250 shares per contract.
Open Interest: Open Interest refers to the total number of outstanding positions on a particular options contract across all participants in the market at any given point of time. Open Interest becomes nil past the expiration date for a particular contract.
Exercising of an option contract: Exercising of an option contract is the act of claiming your right to buy the options contract at the end of the expiry. If you ever hear the line ?exercise the option contract? in the context of a call option, it simply means that one is claiming the right to buy the stock at the agreed strike price. Clearly he or she would do it only if the stock is trading above the strike. Here is an important point to note ? you can exercise the option only on the day of the expiry and not any time before the expiry.
American and European Options: The terms ?American? and ?European? refer to the type of underlying asset in an options contract and when it can be executed. American options? are Options that can be executed at any time on or before their expiration date. ?European options? are Options that can only be executed on the expiration date.
Please note that in Indian market only European type of options are available for trading.
This article is to give you a brief introduction about ?Options?. In our next article ?PART-II? we will discuss more detail with real-time example and also learn some more like ?Option Greeks?. To read more stay tuned with us?