Options, are another type of derivative instruments. Some people might say options are bit complex; but it can easily be defined by a single word: choice. In other words, all financial contracts are based upon locked-in commitments for both buyer and seller—except options. Buying an option allows you to have choices. Options are also contracts like futures. In options, you can see the developments a bit down the road and then decide if you wish to make or take delivery at the original price. Here you have the choice and that lowers your risk. You can allow unfavorable deals to expire and walk away. Sound good ! right? But please remember, it isn't free. The price you must pay to buy an option is called its premium.
So when you buy an option, it is like buying a price insurance policy. Your risk is limited to your premiums. Depending on how events unfold you can be protected against certain price moves and may receive monetary compensation.
On the other hand, if you sell options, you are granting insurance to someone else. If certain unfavorable events unfold, you must compensate the other party and it might be highly expensive.
Let's look at two simple examples of Infosys options:
Let us assume that Infosys stock is Rs.100 a share now. If you want protection against the price going down over the next 6 months, you would buy a 6-month Infosys Rs.100 put (cost: say 7.50 per share). Now, if the price of Infosys falls to Rs. 80 during the next 6 months, you are protected at Rs. 100 since you are allowed to put (sell) the Infosys stock to the option grantor and receive Rs.100 a share. It did cost Rs.7.50 per share for the insurance, though, so you have lost that, but you protected yourself against a Rs.20 drop.
Let assume that Infosys stock is Rs.100 a share now. If you want protection against the price going up over the next 6 months, you would buy a 6-month Infosys Rs.100 call (cost: say Rs.9.20 per share). [Note: The put cost is Rs. 7.50, but the call cost is Rs.9.20. This is typical of spot options because the forward price is considered the fair price of Infosys stock. If spot Infosys stock is trading at Rs. 100, the 6-month forward is worth Rs. 101.70 at 3.4 percent rates. If so, the right to call (buy) it at Rs. 100 is worth about Rs. 1.70 per share more than the right to put it at Rs. 100. You might want to own Infosys share, but you haven't yet done so and you are afraid the market may get away from you. This call gives you the choice during the next 6 months of buying Infosys stock from the option grantor for Rs. 100 a share no matter what price it is trading for at that time. Hope the concept is more clear to you.
Calls and Puts
The two types of options are calls and puts: They have been given the names Calls and Puts, which, respectively, give you the choice of buying or selling, if you choose to do so. Puts and calls are mirror images of each other. The first protects the downside; the second protects the upside.
But the difference of option is that you need not sell or buy if it is not beneficial to you. Thus, you do not have an obligation, but a choice. Only options allow this choice. As a comparison, forwards and futures are locked-in obligations in which you must deliver on the agreed date whether you like it or not. Options can be as speculative or as conservative as you want. This means you can do everything from protecting a position from a decline to outright betting on the movement of a market or index.
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Call buying is the simplest way of trading call options. Novice traders often start off trading options by buying calls, not only because of its simplicity but also due to the large ROI generated from successful trades.
An Example :
Suppose the stock of Reliance company is trading at Rs 40. A call option contract with a strike price of Rs.40 expiring in a month's time is being priced at Rs.2. Mahesh strongly believe that Reliance stock will rise sharply in the coming weeks after their earnings report. So Mahesh paid Rs.200 to purchase a single Rs.40 reliance call option covering 100 shares.
Say Mahesh was spot on and the price of Reliance stock rallies to Rs. 50 after the company reported strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, Mahesh's call buying strategy will net him a profit of Rs.800.
How to understand the above pay off diagram
The horizontal line across the bottom (the x-axis) represents the underlying instrument - in this example, the share price of Reliance. The vertical axis illustrates our profit/loss as the shares move up or down. The blue line is our payoff. You can see that the vertical distance between the 0 profit line and the blue line is our maximum loss, i.e. the amount we paid for the option. So, anywhere under our break even point of 42 means that the option isn't profitable and we will not exercise and we will lose any premium we paid. If the market crashes and the stock goes bankrupt, our maximum loss will still only be the premium we paid.
However, as the shares trade past the Rs.42 mark we start making money. If, at expiry, Reliance shares are trading at Rs. 50 then we will make Rs. 10 per share. In our example, as each call option contract covers 100 shares, the total amount, he would receive Rs.1000. Since Mahesh had paid Rs. 200 to purchase the call option, his net profit for the entire trade is Rs. 800.
This strategy of trading call options is known as the long call strategy. Now another question may arise? Who will pay this difference of Rs.800? The Option Seller/Writer will pay this difference of Rs.800 to the exchange, who in-turn will pay your broker and your broker will pay you. This settlement is called automatic exercise of the Option.
Note: Instead of purchasing call options, one can also sell (write) them for a profit. Call option writers, also known as sellers, sell call options with the hope that they expire worthless so that they can pocket the premiums. Selling calls, or short call, involves more risk but can also be very profitable when done properly.
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.
Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.
Suppose the stock of reliance company is trading at Rs 40. A put option contract with a strike price of Rs.40 expiring in a month's time is being priced at Rs.2. Our Mahesh strongly believes that Reliance stock will drop sharply in the coming weeks after their earnings report. So he paid Rs. 200 to purchase a single Rs.40 reliance put option covering 100 shares.
He was spot on and stock plunges to Rs. 30. With this crash in the underlying stock price, Mahesh's put buying strategy will result in a profit of Rs.800.
Let's take a look at how we obtain this figure.
Since price has fallen, Mahesh would exercise put option he would invoke his right to sell 100 shares of Reliance stock at Rs. 40 each. Although he doesn't own any share of reliance company at this time, he can easily go to the open market to buy 100 shares at only Rs. 30 a share and sell them immediately for Rs.40 per share. This gives him a profit of Rs.10 per share. Since each put option contract covers 100 shares, the total amount he would receive is Rs. 1000. So minus the initial amount paid, his net profit is Rs. 800. This strategy of trading put option is known as the long put strategy.
Note: Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.