Technical Analysis

Understand this option

Shaurya Mishra | Updated on July 07, 2012 Published on July 07, 2012

In derivatives, option is a contract between two parties for a future transaction on an asset at a reference price (the strike).The buyer of the option has the right, but not the obligation, to honour the contract, while the seller has the obligation to fulfil the transaction, if the buyer intends to do so.

Since the buyer has a positives payoff while the seller has to take the risk in case the buyer does not buy the asset, to compensate for this risk the buyer has to pay some premium to the seller of the option. The party which sells the option is called the ‘writer’ of the option.

There are two types of options, call and put options

A call option gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

A put option gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short option on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

The mechanics of the options trading is illustrated with the following example.

Suppose an investor A is bullish on Infosys stock which is trading at Rs 2,400, but she/he does not want to commit full capital on a single stock as there is a risk of the stock not performing according to the expectations.

So instead of buying the stock, A buys a call option of Infosys stock which expires in one month (you can choose other time periods too depending on your investing strategy). Assume there is other investor B who does not share A’s belief and will be happy to enter into a contract with investor A.

But there is a caveat here, what if investor A is right and the stock rises more than Rs 2,400 after one month and even if A is wrong what is the incentive for B to enter into this type of contract. To compensate for this risk, investor A has to give some premium to investor B. This premium is called option premium and is similar to the premium you pay for your insurance scheme. It can be easily inferred that investor A has an unlimited upside potential (what if stock rises to Rs 10,000) whereas investor B has unlimited downside.

Lets assume the premium for entering into this contract is Rs 100.So if the stock price is Rs 3,000 at the time of expiry then investor A exercises his option and investor B is obliged to fulfil the contract and thus giving Rs 600 (Rs 3,000-2,400) to investor A. Net payoff for investor A is Rs 500 (600-100). If the stock price is less than Rs 2,400 then investor A does not bother to exercise his option and thus investor B ends up with Rs 100. Here Rs 2,400 is the strike price and the exercise price is the price at which the buyer of the option exercises his contract.

Put options also works in the same way, the difference being that the buyer of the option gains if the stock price falls below the total of strike price and premium. Besides the maximum gain is capped, since price cannot fall below zero.

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