L1 : Introduction to Options
“Imagine…. Having the power to own something in the future, at the current price or at any price which we choose, and not worry about the uncertainty of future price movements” - Options trading gives you the power to achieve this.
What are Options?
Options are a financial derivative product whose value is derived from the value of the underlying asset. There are two parties involved in Options trading. Option Buyer and Option Seller.
The Option buyer has the right to buy the underlying asset on or before the expiry of the contract. And Option seller is obligated to honor the agreement on or before the expiration of the contract.
We have used various terminologies like Expiry, contract, right, obligation, etc, we will be talking about each and every concept in detail in the chapters to follow.
Let us understand the mechanism of options trading with the help of a case-based scenario:
Say, there are two parties (Ram & Shyam) entering into an agreement to buy and sell a piece of land from each other at a fixed price of Rs. 10,00,000, three months down the line.
Now, the following scenarios are possible three months down the line
- Either the price of land goes up to Rs. 12,00,000. Then Ram stands to gain in this scenario. His gain amounts to the difference between the agreed-upon price and the current price of land (Rs. 2,00,000) and the same amount will be loss for other party (Shyam)
- Or, the price of land falls to Rs. 8,00,000. In this case, the seller (Shyam) stands to gain. His gain amounts to the difference between the agreed-upon price and the current price of land (Rs. 2,00,000) and the same amount will be loss for buyer of the land (Ram)
- Or, the price of land remains unchanged. In this case, both the parties involved neither lose or gain in this contract.
Now, if we were to apply the logic of Options in the above example, then
Ram: Buyer of Land, will be called the Option Buyer, he buys the right from Shayam to buy the piece of land at an agreed-upon price three months down the line by paying a premium
Shyam: The seller of land, will also be called as the Option Seller, he sells his right on the land at a fixed price and receives a fee (in the form of premium) from the buyer (Ram)
Expiry Period: Three months fixed duration
Now, if the above contract were an options contract, and if the price of land goes up upon expiry, then the buyer of land stands to gain Rs. 2,00,000. And, if the price goes down, then the buyer does not have to honour the contract as he has bought the right and is not obligated to honour the contract. He just stands to lose the premium (gain for the seller of the contract).
Various Option Types:
There are generally two types of Options - Call Option and Put Option. The call option gives you the right to buy the underlying asset upon expiry and a Put option gives you the right to sell the underlying asset upon expiry.
These are the type of options that gives you the right to buy the underlying asset at a predetermined price in the future. Now, why would someone lock the price right now?
Only, when they are expecting that in the future the underlying asset would become more expensive to buy. A Call option is bought if one is having a bullish stance on the market and is expecting the price of the underlying asset to substantially rise in the future.
Say, I have a bullish view on the share price of Reliance Industries (RIL). Say, The current share price of RIL is Rs. 2000 and I enter into an agreement with the seller of the option to buy the same at Rs. 2050, one month down the line.
Now, if after one month, if the share price of RIL goes to Rs. 2125, then the benefit for the buyer of the option will be
= Rs. (2125-2050)
= Rs. 75 per share
Again, if the share price goes to Rs. 2050, then he does not have to exercise the option because for the buyer to make a profit, the share price upon expiry will have to go beyond the strike price. He merely stands to lose the premium.
And, say if upon expiry, if the share price remains unchanged or goes down, then also the buyer will not exercise the option and he merely stands to lose the premium paid at the time of entering the options contract.
These are the type of options that give you the right to sell the underlying asset at a predetermined price in the future. Now, why would someone lock in the selling price right now?
Only, when they are expecting that in the future the underlying asset would become cheap and can be bought at relatively discounted value. A Put option is bought if one is having a bearish stance on the market and is expecting the price of the underlying asset to substantially fall in the future.
For the sake of clarity, we will be continuing with our example of Reliance Industries. Say, if I have a bearish vision on the share price of RIL and I see a dip in the prices before ascending up. So, to express my bearish stance, I buy a Put option and if the market goes in line with my expectations, I stand to gain from the falling price of Reliance Industries.
Current Price of RIL = Rs. 2000
Stance = Bearish
Expected price 1 month down the line =below 1950
Put option bought = 1950 PE
So, if the price falls below 1950 in one month’s time, the buyer of the Put option stands to gain. But if the price stays above 1950, then the put option holder loses only the premium which he paid to buy the put option.