Options: Kick off

OPTIONS

Options are slightly complex than futures. We’ve already discussed the meaning of option contracts. From this article onwards, we’ll proceed to break up various aspects of options just like we did with futures.

Options are traded in the exchanges just like futures. At any given point of time , there would be three outstanding contracts – near month contract, mid month contract and far month contract. Option Contracts expire on the last Thursday of the expiry month. So, all those features are common between futures and options.

BUYERS AND SELLERS.

In any market, there would be both buyers and sellers. The option market is no different. There would be buyers and sellers for option contracts. You can buy/sell two ‘categories’ of options – calls and puts. As already mentioned in our introductory article on options, buyers are called ‘holders’ and sellers are called ‘writers’.Straight and simple.

Now, we would like to discuss just two points in this article.

EVERYTHING IS AT YOUR OPTION... ( If you are the buyer !! )

That’s the first point.

As a buyer, you are the king– it doesn’t matter if you bought a call or a put – if you’re the holder, what you hold is a right. The peculiarity of this right is that, it is not at all necessary that you should exercise this right!!  You would proceed to exercise the right only if it’s favorable for you.

So, as a buyer you have two choices – you can  buy a call or buy a put.

If you’re buying a call – That gives you the ‘right’ to buy the underlying asset (i.e., stocks) within a certain period at a specified price, called the strike price.  It’s just a right. At the end of the contract, it is not necessary to exercise the right. It’s your option.

If you’re buying a put – That gives you the ‘right’ to sell the underlying asset within a certain period at a specified price (strike price). Again, it’s just a right. At the end of the contract, it’s not at all necessary to exercise the right. It’s your option.

So, if markets move according to your calculations, you’d jump in and exercise the right and make money. Or else, you’ll leave the right to lapse.

For example –

  • The shares of reliance are trading at Rs 650 and according to your calculations, the stock would move up to Rs 750 in 25-30 days. But since there is nothing called 100% surety in stock markets, you also fear that if some negative news breaks out, the stock would plummet to Rs 590 or below. Reliance’s near month options are available at a strike price of Rs 670. Now, how do you take advantage of this situation and at the same time protect yourself?

Buy reliance call option – That gives you the ‘right’ to buy Reliance shares at Rs 670 anytime within 30 days. It’s just a right. At the end of the contract, it is not necessary to exercise the right. It’s your option. If everything works out according to your calculations, then 30 days later, the stock would be trading at Rs 750 and you’d immediately exercise the right to buy at Rs 670 and sell at Rs 750. The difference is your profit.

Now suppose – the price of reliance drops to Rs 590. You being the call holder at Rs 670 (strike price) would not be interested in buying at Rs 670 anymore. So you’ll not exercise the option and the option lapses.

NOTHING IS AT YOUR OPTION… ( If you’re the seller..!!)

That’s the second important point.

As a seller, you’re the slave – it doesn’t matter if you’ve sold a call or a put – if you’re the seller, what you sold is a right. Since rights are sold,  if the guy who bought the right from you opts to exercise his option, you are bound to obey. There’s no option.

Here also, as a seller of options – you can sell a call or sell a put.

If you’re selling a call – That gives the buyer the ‘right’ to buy the underlying asset from you within a certain period at a specified price, called the strike price. At the end of the contract, he may or may not exercise the right. It’s his option. You as a seller have a definite obligation to sell.

If you’re selling a put – you’re selling the ‘right’ to sell the underlying asset within a certain period at a specified price (strike price). At the end of the contract, if the buyer of the put option wants to sell it to you, you’re obligated to buy the stock at a predetermined price.

So if you’re the seller of a put or call, you are always obligated. Your performance is compulsory. As a seller of options, your gain is always limited but your possibility for losses is unlimited. So, selling options is very risky.

It’s perfectly all right for beginners to get confused towards the end. In that case, go back to the options definition, and the then come back and read once again. You’ll get the clear picture.

You may like these posts:

  1. Types of derivatives 3 – Options contract
  2. Futures: Understanding the basic terms
  3. Types of derivatives 2 – Futures contract

1 Response to “Options: Kick off”

Adarsh

August 31, 2013 at 1:01 am

Hi Victor,
Really impressed with yuor style of describing options. Hats off!!!

It would be helpful if you explain Futures and Options with a couple of examples which also include how much money we need to keep in our trading account for futures and also for options. Can we trade with less balance in account say 5000-10000.

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