Types of derivatives 3 – Options contract

We discussed forwards and futures. The next derivative instrument is options.
Before we move on, here are two stock market games for you to play.

TWO GAMES AT YOUR OPTION !

Game 1.

Share price of a company, say Wipro, is at Rs 300 now.  For a small fee of Rs 3 per share, you will be given the right to buy 1000 shares. The condition is that if price moves up and strikes Rs 390, you keep the gain on 1000 shares. If price falls, you need not suffer the loss on 1000 shares. You lose only that small amount you paid for participating in the game.

So, if you win, you make a lot of money. For example – If the price moves up to Rs 390, you gain Rs 90,000 (1000 x 90) less Rs 3,000(3 x 1000). If price falls, you’ll let go a small amount of Rs 3,000 for playing that game.

  • The benefit is- Unlimited gains. Limited loss.


Game 2

Share price of a company, say Wipro, is at Rs 300 now. The price of the share is expected to fall to Rs 250 per share. For a small fee of Rs 3 per share, you will be given the right to 1000 shares. If price falls as expected, you keep the difference on 1000 shares. If price moves up, you lose that small amount you paid for participating in the game.

So if the stock strikes 250, you gain Rs 50,000 (1000 x 50) less Rs 3000 (1000 x 3). If the price went up contrary to expectations, you lose the small amount paid as fee.

  • Limited gains. Limited loss.

In reality, Do we have such games ?

  • The answer is , ‘yes’.  The game is called options.


CRACKING THE GAME CODE.

Game 1 is called a call option. What you did  is, buying a call option.

Game 2 is called a put option. What you did is, buying a put option.

As a buyer of calls or puts, you’re henceforth called the ‘holder’.

Where is this game played?

  • In the stock market, of course. Options are bought and sold at the stock markets.

Who starts the game?

  • The stock exchange. The exchange would introduce the game and set the ball rolling.

Which game should you play?

If you expect the stock price to rise, you play game 1, that is, you buy a call option. If you expect the price to fall you play game 2, that is, you buy a put option.

Who sells?

That’s right. The game is played in the stock exchange and all I am taking about is ‘buying’ call options and put options. But how can you buy unless there someone to sell the same?

There are sellers. They are also called writers. Those are game participants who think contrary to your views. They expect the price to fall, so they sell a call option (Recall game 2 – Alternatively, they could have bought a put option).

If they expect the price to rise, they sell a put option. (Alternatively, they could have bought a call option)

A logical doubt –

As implied from the above paragraph, if someone expects the price to rise, they sell a Put option. Alternatively, they could have played game 1- buy a call option. Both have the same effect, I am right?

  • No.

Why?  Both actions are based on the calculation that a stock price will rise. The buyer of a call and the seller of a put share the same opinion about the price direction of the stock. But that’s where the similarity ends

A person chooses to buy a call when he reasonably thinks that the prices are moving up. If he was 100% certain that the price would move up, he would have bought the shares itself, and not options! Similarly, a person chooses to buy a put when he reasonably thinks that the prices are moving down.

But sellers of calls and puts basically do it for some other reason. They are actual shareholders who want to protect themselves from price volatility and at the same time make some money out of it. Since they ‘sell the right’ , Sellers are obligated to perform their part. There’s no option.

Option strategies will be discussed in  later articles. For the time being, it important to keep things simple.

Before I finish this introductory article, here’s the summary of what we’ve discussed. It’s cut into 3 parts. Make sure you understand part by part.

Section 1

  • Option contracts are introduced by the stock exchanges.
  • There are two types of options – call option and Put option. Call = right to buy, put = right to sell.
  • You can buy or sell any of these options.
  • If you are a buyer, you’re called the ‘holder’ of an option. Buy= hold
  • If you are a seller, you’re called the ‘writer’ of an option. Sell = write

Section 2

  • You can hold a call or hold a put. As a holder of option, you have the ‘option’ to buy or sell and not an obligation.
    • Depending on the price movement, a call holder may get unlimited gains or limited loss. A put holder has only limited Loss and limited profits.
    • You can write a call or write a put. As a writer of option, you are obligated to perform. You have an obligation to sell if you’ve written a call and you have an obligation to buy if you’ve written a put.
    • Depending on the price movement, a call writer may suffer unlimited loss or limited profit. A put writer has only limited loss and limited profits
    • Writing, since it carries obligation, is risky.

Section 3

  • When you’re bullish on a stock, you BUY CALL OPTIONS which gives you the right to buy that share at the present price at a future date. So, in future, when the price moves up, you stand to gain. Contrary to your expectations, In future, if the price of the stock falls, you will not exercise your right to buy at present price. The only loss is the commission paid for buying call options.
  • When you’re bearish on a stock, you BUY PUT OPTIONS which give you the right to sell that share at the present price at a future date. So, in future, when the price moves down, you stand to gain. Contrary to your expectations, in future, if the price of the stock shoots up, you will not exercise your right to sell at the present price. The only loss is the commission paid for buying put options.
  • You WRITE options to control risk of shares you hold or to lock in profits or to gain from writing.

You may like these posts:

  1. Types of derivatives 2 – Futures contract
  2. Types of derivatives 1 – Forward contract.
  3. Introduction to Derivatives.

7 Responses to “Types of derivatives 3 – Options contract”

VIKRAM PATEL

January 1, 2012 at 12:36 am

DEAR SIR
I FOUND ARTICLE VERY MUCH USEFUL.PLEASE SEND ALL ARTICLES IN FUTURE.
I REQUEST YOU TO SEND HOW TO TRADE SUCCESSFUL IN OPTIONS &IN FUTURE STOCKS.
THANKS
JAISWAMINARAYAN
VIKRAM PATEL
AHMEDABAD

ss

April 3, 2012 at 12:04 am

thanks a ton

TL

March 5, 2013 at 5:40 pm

Hi Victor,

As when somebody is opting for “Put option” as per Game 2. hes can make unlimited profit as the stock can fall upto any limit. But you had mentioned limited profit and limited gain. Could you pls direct me if I am wrong??

J Victor

May 4, 2013 at 6:51 pm

hey TL ,i think i missed your comment.
The stock price can drop only till it reaches ’0′ and not beyond that. So the maximum profit for a put holder is definitely limited.
The loss is also limited since, if the calculations go wrong, a put holder will not exercise his option and hence the maximum loss is limited to the amount paid for buying puts.

Jmy

June 3, 2013 at 6:16 am

I wanted to know if I have understood it correct..

According to GAME 1 :

Current price of LIC Housing Finance dated 3rd June is Rs 257.50/-

Suppose I buy 1 lot i e 1000 share at Rs. 5/share for 25 July 2013 CE 280.00 (Strike Price) (is this valid?)

Does that mean if the price touches 280 during any day from today to 25th July I make a profit of Rs 23 x 1000 shares = Rs 23,000 and my loss will be limited to Rs 5000 i e Rs 5 x 1000 Shares?

Sumukhpbhat

October 17, 2015 at 12:48 am

Super..analysis and convinced….

DEVENDRA

January 3, 2016 at 2:59 pm

these are called professional example to teach something difficult topic

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