What is an option and types of options? How options are
traded?
Many people get confused when it comes to the
topic of OPTIONS. Isn’t it?
An option is
a financial derivative that represents a contract sold by one party (option
writer) to another party (option holder). The contract offers the buyer the
right, but not the obligation, to buy (call) or sell (put) a security or other
financial asset at an agreed-upon price (the strike price) during a certain
period of time or on a specific date (exercise date).
Most confusing about options understanding is that which party has a
right and which party has an obligation? Who can be at larger loss and for whom
losses are limited? For getting some clarity let’s begin with basic definitions
of call and put option.
Call Option: A Call is a right,
not an obligation to buy an underlying asset at a
predetermined date at a predetermined price by paying a certain amount upfront
Put Option: A Put is a right,
not an obligation to sell an underlying asset at a
predetermined date at a predetermined price by paying a certain price upfront.
You buy Call Options when you think a share is going to go up in value
and you buy Put options when you think a share is going to go down in value.
This means that the value of your Calls go up as the stock rises, while the
value of your Puts go up when your share falls.
Let us take example of NSE Options Chain to better understand how options really work!
The above screenshot has been taken from the Options chain sectionof the NSE website, and this shows the Call Option and the Put Option
details for NIFTY which expires on 30th June 2016 (nearest future).
Every Option has an expiry date and the Option becomes worthless on that expiry
date. The expiry date is the predetermined date in
the definition.
Refer
to Calls Side (left)
The Strike Price which is the right most column shows at what price you
will be buying Nifty. This is a Call option to buy components of the Nifty, so
the Nifty is the underlying asset from
the definition.
Now, if you look at the sixth column from the left of this picture –
that’s “LTP” which stands for “Last Traded Price” and this shows
you at what cost per unit the
last transaction happened for this contract.
The Nifty closed at 8,170 this week, and let’s look at
the last highlighted (light yellow) row in this picture
which is for the strike price of 8,150 (closest strike price of table)
and see how that fits our definition.
This Call is a right, not an obligation to buy Nifty
at a predetermined date of June 30th 2016 at a predetermined
price of Rs. 8,150 by paying Rs. 135 (LTP) per unit upfront.
So if you bought this contract today,
you will have to pay Rs. 135 and in return you will have the right to buy a
Nifty contract at Rs. 8,150 on June 30th 2016.
If Nifty is at say 8,500 on that date, then your Call option will be worth a
lot more than Rs. 135 because you can buy
it at 8,150 and then sell it at 8,500 (gross margin of Rs. 350). That’s also why in the image above
you see that the price of the Options keep increasing as the Strike Price keeps
going down. Chances of achieving higher nifty price (8,500; 8,600; 9,000) is
less likely to occur in near future.
If
the Nifty closes below 8,150; the Option will expire worthless because why
would you buy Nifty, say at 8,000
when you can buy it for lower in the market. The part of the definition where
it says that the Option is a “right but not an obligation” comes
into play here because if Nifty closes below what you paid for it then you
don’t have to do anything at all as it is your right to buy, but you aren’t
obligated to buy.
This
means that when you buy a Call Option your loss is defined to what you paid for
it (which is called margin). You can’t lose more than that on the transaction.
The
seller of the Call however who is known as the person who writes the option doesn’t have a cap on how much he
loses and can lose an unlimited amount (theoretically) in the transaction. This
is because the person who writes the option has an obligation to sell you the
underlying asset at the price decided in the contract.
Details about how put options work (right side of picture) will be
covered in next article.
very nice..
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