Narach Investment

TYPES OF OPTIONS


An option is a contract between two parties giving the taker (or buyer) the right, but not the obligation, to buy or sell a parcel of stocks (or shares) at a predetermined price; possibly on or before a predetermined date. To acquire this right the buyer pays a premium to the writer (or seller) of the contract.

There are two types of options; namely:

We shall discuss both these types of options. You are advised to follow the thought, to understand the concept. The names and the prices in the illustrations below are not in real time and have only been used to help explain these options.

Call Options: The call options give the taker (or buyer) the right, but not the obligation, to buy the underlying stocks (or shares) at a predetermined price, on or before a determined date.

Illustration 1: Let's say Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call at a Premium of 8.

This contract allows Raj to buy 100 shares of SATCOM at ₹150.00 per share at any time between the current date and the end of August. For this privilege, Raj pays a fee of ₹800.00; that is ₹8.00 a share for 100 shares.

The buyer of a "call" has purchased the right to buy and for that he pays a premium.

Now, let us see how one can profit from buying an option.

Raj purchases a December Call option at ₹40.00 for a premium of ₹15.00. That is he has purchased the right to buy that underlying share for ₹40.00 by the end of December. If the price of the underlying stock rises above ₹55.00 (that is ₹40.00 + ₹15.00) he will break even and start making a profit. However, to book this profit he would have to exercise this option on or before the expiry date. Now, suppose the price of the underlying stock does not rise but falls. Then Raj would choose not to exercise the option and forgo the premium of ₹15.00 and thus limit his loss to this amount only.

If the Premium = ₹15.00 and the Strike price of the Call Option = ₹40.00, then the Break even point = ₹15.00 + ₹40.00 = ₹55.00. That is to say that the price of the underlying stock would have to rise to ₹55.00 before Raj would break even in his transaction.

Let us take another example of a Call Option on the Nifty to understand the concept better.

Let's say Nifty is at 1310. The following Nifty Options are trading at the following quotes:

OPTIONS CONTRACT STRIKE PRICE CALL PREMIUM
December Nifty 1325 ₹6,000.00
  1345 ₹2,000.00
January Nifty 1325 ₹4,500.00
  1345 ₹5,000.00

A trader is of the view that the index or Nifty would go up to 1400 in January, but does not want the risk of prices going down. Therefore, he buys 10 Options of January contracts at 1345. He pays a premium for buying these Call Options (that is the right to buy these contract) for ₹500.00 × 10 = ₹5,000.00.

In January, the Nifty index goes up to 1365. He sells the Call Options or exercises the option and takes the difference between the Nifty Spot and the Strike price of his Call Option contracts (that is ₹1365.00 − ₹1345 = ₹20.00). Now the market lot of the Nifty contract is 200. So, the trader books a profit of ₹20.00 × 200 = ₹4,000.00 per contract. Now, as he had bought 10 Call Options contracts his total profit would be ₹4,000.00 × 10 = ₹40,000.00.

He had paid ₹5,000.00 towards the premium for buying these Call Options. So he would have earned ₹40,000.00 less ₹5,000.00 which is ₹35,000.00 when he exercised these Call Option contracts.

If, on the other had the Nifty had fallen below 1345, then the trader will not exercise his right and would opt to forego the premium of ₹5,000.00 he had paid initially. So, in case the Nifty falls further below the 1345 level the traders loss is limited to the premium he paid upfront, but the profit potential is unlimited.

Call Options: Long and Short Positions:

Put Options: A Put Option gives the holder the right to sell a specified number of shares of an underlying security at a fixed price for a period of time.

Let's say Raj purchases 1 Infosys Technology Aug 3500 Put − Premium 200.

This contract allows Raj to sell 100 shares of Infosys Technology at ₹3,500.00 per share at any time between the current date and the end of August. To have this privilege, Raj pays a premium of ₹20,000.00 (that is ₹200.00 per share for 100 shares). The buyer of a put has purchased a right to sell.

To explain this further, let's say Raj is of the view that a stock is overpriced and its price would fall in the future, but he does not want to take the risk in the event of the price rising. So, he purchases a Put option at ₹70.00 on Stock 'X'. By purchasing the put option Raj has the right to sell the stock at ₹70.00, but he has to pay a premium of ₹15.00 for this contract.

So Raj would breakeven only after the stock falls below ₹55.00 (that is ₹70.00 less ₹15.00) and would start making a profit on this contract when the stock price falls below ₹55.00.

Let us illustrate this further. A trader on 15 December is of the view that Wipro is overpriced and would fall in the future, but does not want to take the risk in the event the price rises. So, he purchases a Put option on Wipro. The quotes are as under:

The trader purchases 1000 Wipro Put at Strike price 1070 at Put price of ₹30.00. He pays a Put premium of ₹30,000.00. His position in the following price points situations is discussed below:

  1. Jan Spot price of Wipro = 1020
  2. Jan Spot price of Wipro = 1080

In the first situation, the trader has the right to sell 1000 Wipro shares at ₹1,070.00 , the Spot price of which is ₹1,020.00. By exercising the Put option he earns ₹(1070 - 1020) = ₹50.00 per put, which totals ₹50,000.00. His net income is ₹50,000.00 less ₹30,000.00 (that is the premium paid upfront) = ₹20,000.00.

In the second price situation, the price is higher in the Spot market, so the trader would not sell at a lower price. In this case he would have to let his Put option expire unexercised. His loss here would be initial premium paid for the Put option contracts, that is ₹30,000.00.

Put Options: Long and Short Positions: Call Options and Put Options: Long and Short Positions:
  CALL OPTIONS PUT OPTIONS
If you expect a fall in price (Bearish) ShortLong
If you expect a rise in price (Bullish) LongShort
We have provided a matrix below to summarize the above discussion on Call and Put options:
CALL OPTION BUYER CALL OPTION WRITER (SELLER)
Pays the premium Receives the premium
Has right to exercise and buy the underlying shares Obligation to sell shares, if contract is exercised
Profits from rising prices Profits from falling prices or remains neutral
Limited loss, potentially unlimited gain Potentially unlimited loss, limited gain
PUT OPTION BUYER PUT OPTION WRITER (SELLER)
Pays the premium Receives the premium
Has right to exercise and sell the underlying shares Obligation to buy the shares if contract is exercised
Profits from falling prices Profits from rising prices or remains neutral
Limited loss, potentially unlimited gain Potentially unlimited loss, limited gain

For a better understanding of options, we would suggest that the investor read about role of options and futures ; what are options? ; option styles, class and series and option concepts . We would strongly recommend that the investor first study these investment instruments; conduct dry runs with pen and paper; understand the nuances of the dynamics of the underlying security and the connectivity between the various risks that he or she would be taking on during the pendency of a futures or options position held by him.