Knowledge Series : Options – An Introduction

What are Options?

An option is an contract between the buyer and the seller that gives the buyer of the contract, the right but not the obligation to buy or sell the underlying asset at a pre determined price on or before a certain date. The pre determined price or the agreed price is called the Strike Price and the date on which the option contract expires is known as the Expiration Date.

In return for granting an option, the seller collects a premium. This is known as Selling or Writing an option.

The price of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility.

Before going into the details of the different types of options, let us take a simple real life example into what an option actually is.

Let’s assume there is a property being sold at a particular area for 2 lakhs. You want to buy that property but you don’t have enough money right now and you need 3 months to arrange for the money. So you talk to the owner and reach an agreement that you will pay him Rs. 5000(premium) now and that the owner will sell his house at 2 lakhs(strike price) after 3 months(expiration date). Now two situation may arise during the period of 3 months :

1. Suddenly the government has decided to improve infrastructure and accessibility in that area. In this case the property price shoots upto Rs. 3 lakhs. You can now buy the property for 2 lakhs and immediately sell for 3 lakhs making a profit of Rs. 85,000.
2. Now during the 3 months you come to know that in that area there is water, electricity problem. You think it is not worth to buy. So you now have the right not to buy the property. Your loss only stands at the price which you paid for the contract, i.e. Rs. 5000

So from this example you see that you do not have the obligation to buy the underlying asset.

Types of Options :

Call : A call option gives its holder the right to purchase an asset for a specified price, called the strike or exercise price, on or before some specified expiration date.

The holder will choose to exercise only if the market value of the asset to be purchased exceeds the exercise price.

Put: A put option gives its holder the right to sell an asset for a specified price on or before the expiration date.

A put will be exercised only if the exercise price is greater than the market price of the underlying asset.

An option is known as in the money when its exercise would prduce profit for its holder. When it is unprofitable the option is out of the money. Option are at the money when the exercise price and asset price are equal.

There are two types of participants in an option, buyers(holders) and sellers(writers). The important distinction between the two is that holders are not obligated to buy or sell, however, writers are obligated to buy or sell.

Now consider an example to see the profit and losses on a Call Option.

Consider a March expiration call option on a share of XYZ with strike price of Rs. 110 selling on March 5^th for Rs. 5. In  the Indian exchange options expire on the last Thursday of the month.  On 5^th March XYZ sells for Rs. 107. As the stock price is less than the strike price, it does not make sense to exercise the option. If XYZ is at Rs. 113, you can exercise the option to buy the stock worth Rs. 113 for Rs. 110. The value of the option at expiration date would be

                Value at expiration = Stock Price – Exercise Price = Rs. 113 – Rs. 110 = Rs. 3

Despite Rs. 3 payoff, the holder still realizes a loss of Rs. 2 on the investment because his initial purchase price was Rs. 5.

                Profit = Final Value – Original Investment = Rs. 3 – Rs. 5 = -Rs. 2

So, if the stock price rises above Rs. 115, the call will clear a profit.

American and European Options :

An American Option allows its holder to exercise the right to purchase(if a call) or sell(if a put) the underlying asset on or before the expiration date.

European options allow for exercise of the option only on the expiration date.

In the Indian market Options conract on individual stocks are American options and are cash settled.

We will be back with Option Trading Strategies in our next post.