When it comes to the trading of securities in the financial market, our imagination may restrict us to believe that it’s all about trading of equity with profit and loss dependent upon share price of different companies. However, in practice, a significant portion of the financial market trading is also managed through derivatives. A derivative in the ordinary term refers to any financial security/contract, the value of which is dependent on or derived from an underlying asset/assets (commonly referred to as only “underlying”). It is, therefore, an agreement between two or more parties that is completely dependent upon the underlying asset, the value of which is bound to change over time due to one or several factors. This change in value leads to profit/loss. Currency, commodities, market indexes, stocks, bonds, etc. form the underlying asset. Various types of derivatives that are useful for hedging from loss, risk management, speculation gains, etc. are forwards, futures, swaps and options. This article will be restricted to options.
Options Contract or simply Options represent an agreement between two parties (buyer and seller of underlying) that facilitates the buyer of the option a right (but not an obligation) to transact i.e. buy or to sell the underlying asset at a specified price (referred to as Strike Price) on a particular date (referred to as Expiration Date). To obtain a buy right (referred to as Call Option) or a sell right (referred to as Put Option), the buyer pays an amount. This amount is recognized as the option premium. There are American Options as well as European Options. While the former can be exercised at any time on or before the expiration date, the latter can only be exercised on the expiration date. There are four types of Options: long call option, long put option, short call option and short put option. The words long and short here refers to the buying and selling of options respectively. Therefore, a long call option means buying a call option whereas a short put option means selling a put option.
WORKING OF OPTIONS
Let’s consider an example of a long call option to understand how everything works:
Let us assume a trader, Say “A” assumes a long call option (i.e. buying an option that gives him right to buy the underlying) on 100 shares of ABC Ltd on 1st January 2020 with an expiration date of 1st February 2020, as he believes that the company’s share price is going to improve due to a new government policy. Allow the stock price (strike price) agreed upon by Mr. A & the other party, “Say B” for the stock of ABC Ltd. be Rs. 200 per share. Also, let the option premium for the same be Rs. 500 for 100 shares.
Now, on 1st February if the market price of 1 share of ABC Ltd. is Rs. 250 per share, then Mr. A can exercise the option and buy it for Rs. 200 per share. This will lead him to a profit of Rs. 4500 (Rs. (250-200)*100 – Rs.500).
In an alternative scenario, if the market price of 1 share of ABC Ltd. reduces to Rs. 150 per share on 1st February opposite to Mr. A’s prediction, then he can refrain from exercising his option and the only loss he will bear is the option premium he paid earlier i.e. Rs. 500.
In a third scenario, if the market price of 1 share of ABC Ltd. remains constant at Rs. 200 per share on 1st Feb, then Mr. A will remain in the same position regardless of the fact that he exercises the option or not.
The example shows how Option is a right but not an obligation to buy or sell assets. Mr. A can either buy the asset or refrain from exercising the option depending upon the market scenario and his Return on Investment (ROI). Note that the option seller is obligated to perform his side of the transaction if the buyer of the call or put option demands so. Similar to long call option, Mr. A can buy the other three types of option depending upon his requirements and can earn a profit, manage extreme risk and reduce speculation losses.
For easier understanding, the profit/loss profile of a few options are mentioned below:
- Long Call – Maximum possibility of profit is infinite with the maximum possibility of loss up to option premium.
- Long Put – Maximum possibility of profit up to (strike price – option premium) with the maximum possibility of loss up to option premium.
The profit/loss profile of Short Call is the mirror image of Long Call and that of Short Put is a mirror image of Long Put. Call options are therefore purchased to leverage appreciation in the underlying price and put option are purchased to gain from price declines. The market for options exists as one can only predict without any certainty as to whether the price of the underlying will increase or decrease a month or a year from now.
Options, therefore, provides a large profit possibility and is used for speculation widely. Therefore investors use options to protect themselves from asymmetric risk. However, once an option expires, it is no longer valid or enforceable. Financial derivatives despite their advantages are risky too as one can never determine a derivative’s real value as it is based on the underlying. The potential for scams is always there. If the time value of money is considered for options, the profit/loss profile also changes. Hence, it is required to know and study a derivative properly before investing to get the most out of it.