As you may know, I covered derivatives, types of derivatives, hedging and futures concepts in the previous article. I also explained the concept of Future Contracts and its uses. Here in Part 2, I am going to discuss another very important derivative called Options. The trading market for Option is so huge and exciting that it commands a dedicated article on itself.
Options
An option is a contract where the buyer has the "right" (depends on buyer to execute it), but not the "obligation" (legally bonded) to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. An option is a security, just like a stock or bond, and constitutes a binding legal contract with strictly defined terms and conditions.
Futures Vs Options
Remember from the previous article, Futures are contracts where both the buyer and the seller have the obligation to honor the contract whereas option does not involve any obligation for both the parties. A contract is a zero sum game i.e. one party will book loss while the other take home the profit. If the contract is futures, the losing party will pay the winning party. However, in options, the buyer will decide whether to execute the contract. You will understand this by the following example.
Let say there is a contract between you and me which says that I will buy one kg of gold at Rs. 1,000 per gm from you on March 1st, 2010. I am the buyer of this contract and you are the seller. So we will either go for cash settlement or you have to deliver the gold to me. Now suppose on the date of settlement i.e. March 1st, 2010, price of gold is Rs. 500 per gram. Thus, the market price of gold on March 1st, 2010 is lower than the contract price.
If the contract were Futures, I would have to buy the gold from you because I have the "obligation" to do so. Hence, I will pay you Rs. 1,000 per gm and you will deliver me the gold. Hence, you make profit while I book loss. Good for you, Bad for me!!
However, if the contract were an Option, I would not have executed it i.e. would not have bought the gold from you. I would have let the contract expire (i.e. do nothing and wait till March 1st, 2010 passes by). How can I do so? I can do it because Options gives me (the buyer) the "right" and not the "obligation" to buy it. Thus, an option would protect me from any adverse movement in the price of underlying asset. In an option, seller has no right because he is compensated by the buyer by paying option premium. Thus, the buyer of an option contract has the "right" but the seller of option contract has the "obligation" to honor the option.
So you may now be wondering that why on earth somebody will ever buy a futures contract when options contract are better. We must know that option has a "premium" attached to it which is called "Options Premium". This is the amount that a buyer of option contract has to pay the seller of the option contract in exchange for higher flexibility and protection against adverse price movement in the value of underlying. Thus, if I have to buy an option contract from you, I will pay a premium to the seller i.e. You.
Options Vs Stocks
In order for you to better understand the benefits of trading options you must first understand some of the similarities and differences between options and stocks.
Similarities:
• Listed Options are securities, just like stocks.
• Options trade like stocks, with buyers making bids and sellers making offers.
• Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Differences:
• Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).
• Options have expiration dates, while stocks do not.
• There is not a fixed number of options, as there are with stocks available e.g. there could tens or even hundreds of options written on the same stock
• Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.
Remember these options are not issued or written by companies who stocks act as underlying asset. These options are generally written by brokers or traders for investors.
Options Terminology
Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the seller.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract from the seller. The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.
Classes of Options
There are two classes of options – American Option and European Option. The key differences are:
1. American option can be exercised before the expiration while an European option is exercised only on the expiration date.
2. Dividends can be issued by the underlying stock in an American option while it is not the case in European option
Types of Options
There are only two types of options: Call option and Put option. In this article we will discuss only European options i.e. options which can not be executed before the agreed upon date.
Call Options
A Call Option is an option to "buy" a stock (underlying) at a specific price on a certain date. The buyer of call option holds the rights while the seller has the obligation to honor the contract. The buyer of a call option enters the contract assuming that the value of underlying will increase in future and benefit him. The seller thinks otherwise i.e. the stock price will not go up and hence the buyer will not execute the contract. So he (seller) will keep the option premium to himself – that would be his profit. Hence, the buyer will execute the contract only when the market price of underlying stock is higher than the strike price.
Example 1 – I bought a call option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 2700 and expiration period is Sep 30, 2010. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock.
How call option helps me (the buyer) in realizing profits. Let us assume that the stock price on Sep 30, 2010 is Rs. 2850. Thus, I will execute the call option and you will sell the stock to me for Rs. 2700 and NOT at the current price. I will take that stock from you and sell it for Rs. 2850 in the open market and book a profit of Rs. 2850 – Rs. 2700 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. Myreturn on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%
Compare this to someone who invested in Infosys stock and NOT in the option. If he bought the stock at Rs. 2000 and sold for Rs. 2500 in the market, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (500* 100 /2500) = 25%
Isn't it great? One golden rule of investment – Don't measure your profit or loss based on "absolute value of profit or loss" but on return on investment (ROI).
Remember this – The buyer of a call option will execute the contract only when the market price of the underlying stock will be higher than the strike price of the stock. This is because the buyer will buy the stock from the seller at a lower cost and sell in the open market to book the difference as profit. However, if the market price of underlying stock is less than that of the exercise price, the buyer will let the option expire. In the above example, if the stock price of Infosys on Sep 30, 2010 were Rs. 2690, I will not exercise the contract! Thus, my only loss would be Rs. 100, the option premium that I paid to the seller (you).
Put Options
Put options are options to sell a stock at a specific price on a certain date. Put options mean "right to sell". It is just the opposite of a call option. The buyer of a put option holds the right to sell while the seller has the obligation to buy. Here, the buyer assumes that the price of underlying asset will go down in future and he will benefit from the put option. Hence, the buyer of a put option will execute the contract only when the market price of underlying stock is lower than the strike price.
Profit realization for the buyer - When do you make profit by selling something? Only when you buy something for X amount and sell it for Y amount where Y>X. Or, you sell someone a product at a price higher than the market price. Why will someone buy a product at a price higher than the market price? He will do it only when he has signed a contract to do so. This is put option which protects and benefits its buyer from any downward movement in the stock price.
State of an option
In-the-Money option – This is when strike price is less than the market price for a call option or the strike price is more than the market price for a put option.
At-the-money – This is when strike price is equal to the market price.
Out-of-the-money – This is when the strike price is more than the market price for the call option while the strike price is less than the market price for the put option.
How to read an option traded listed on an exchange
If you read any business newspaper you may find quotations like this:
INFOSYSTCH Sep 30 CA 2,700.00 51.00 51.00 50.00 51.00
What does this mean? It simply means it is an option with
1. Underlying as Infosys stock
2. Sep 30 is the expiry date
3. to BUY (because it is a "call") Infosys stock - CA is Call Option
4. 2700.00 is the Strike Price
5. The numbers (51.00, 51.00, 50.00, 51.00) shown after the strike are high price, low price, previous close and Last price respectively.
INFOSYSTCH Sep 30 PA 2,700.00 35.00 35.00 52.00 35.00
It simply means it is an option to SELL (because it is a "put") Infosys stock with similar details.
Table1: Representation of rights and obligations
| CALL | PUT |
BUYER (Long) | Right but not the obligation to buy | Right but not the obligation to sell |
SELLER (Short) | Obligation to sell | Obligation to buy |
Common terminology – people who buy options are also called \"holders\" or are considered to be "Long" on option and, those who sell options are also called \"writers\" or are considered as "Short" on option.
Remember this:
Long –> Buy
Short –> Sell (Selling the right to someone else is like buying obligation for oneself)
Call option –> Right to buy
Put option –> Right to sell (Selling the right to someone else is like buying obligation for oneself)
Long call –> Buy the right to buy
Short call –> Sell the right to buy (Selling the right to someone else is like buying obligation for oneself)
Long put –> Buy the right to sell
Short put –> Sell the right to sell (Selling the right to someone else is like buying obligation for oneself)
Hence, if I buy a call option, I will say "I am Long Call" or "I am a Call Holder". People who buy options have a right to exercise.
When a Call is exercised, Call holders may buy stock at the strike price from the Call seller, who is required to sell stock at the strike price to the Call holder. When a Put is exercised, Put holders (buyers) may sell stock at the strike price to the Put seller, who is required to buy stock at the strike price from the Put holder. Neither Call holders nor Put holders are obligated to buy or sell; they simply have the rights to do so, and may choose to exercise or not to exercise based upon their own judgment.
Let us discuss example 1 from the point of view of put option in the next example.
Example 2 – I bought a put option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 2700 and expiration period is Sep 30, 2010. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock. The current price of Infosys stock is say, Rs. 2650.
How put option helps me (the buyer) in realizing profits and protecting my interests. Let us assume that the stock price on Sep 30, 2009 is Rs. 2550. Thus, I will execute the put option and you will buy the stock from me at Rs. 2700 and NOT at the current price which is Rs. 2550. Thus, my profit is Rs. 2700 – Rs. 2550 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%
Compare this to someone who invested in Infosys stock and NOT in the option. The value of Infosys stocks has come down from Rs. 2650 to Rs. 2550; hence, his profit would be
= (Profit * 100 / Total Cost or investment) %
= i.e. a loss of 3.77%.
Gain, Loss and Breakeven Table
|
| Calls | Puts | ||
| Long | Short | Long | Short |
Maximum gain | Infinite | Premium | Limited |
|
Maximum loss | Premium | Infinite |
|
|
Breakeven | Market price = Strike Price + Premium | Market Price = Strike Price - Premium | ||
Potential Benefits of Options
• Greater return for smaller amount invested
• Less risk
• Less initial investment
• Diversify portfolio
These previous examples introduced how options can provide investors with more alternatives, allowing them to specify, precisely, the amount of risk they are willing to take in their holdings. If used on a 1-to-1 basis with the underlying shares, then options can be used to invest in stocks with limited risk, to insure stock investments held, or to set levels of market exposure consistent with one\'s investment strategy. Options can also be used as alternatives to stock investments (one option for each 100 shares), giving investors the ability to profit from favorable market moves just as if they held the underlying security, but with lower potential risk due to a lower initial investment.
Final few words
I know you have to read a lot of things which might sound vague and confusing, which is totally understandable. It took me few weeks to completely understand the concepts of F&O! I am not kidding. However, they are wonderful concepts and knowing them only add to your investments knowledge and profile. Go through both Part-1 and Part-2 regularly for sometime. To help you, I have decided to introduce a section on Q&A to test what you learnt in this article. I will publish the answers in the next article.
Test your skills
1. __________ option conveys the right to Buy.
A. Call
B. Put
2. ________ option conveys the right to Sell.
A. Call
B. Put
3. Long on an option means_____.
A. Buy
B. Sell
4. For a call option when the strike price is more than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money
5. For a put option when the strike price is less than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money
6. The buyer of a call option will exercise the option when ____.
A. Strike price is higher than the market price
B. Strike price is lower than the market price
C. Strike price is equal to the market price
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