Stock markets by their very nature are fickle. While fortunes can be made in a jiffy, more often than not the scenario is the reverse. Investing in stocks has two sides to it:
- Unlimited profit potential from any upside; or
- A downside which could make you a pauper.
Derivative products are structured precisely for this reason; that is to curtail the risk exposure of an investor. Index futures and stock options are instruments that enable the investor to hedge his portfolio or open positions in the market. Options contracts allow you to run your profits while restricting your downside risk.
Apart from risk containment, investors often use options for speculation and can create a wide range of potential profit scenarios.
We have seen in the Derivatives School how index futures can be used to protect oneself from volatility or market risk. Here we shall try to explain some basic concepts of options.What are Options?
Most people remain puzzled by Options. The truth is that most people have been using options for some time now, as options are built into everything from mortgage to insurance.
In the stock markets, an option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. "Option", as the word suggests, is a choice given to the investor to either honour the contract; or if he chooses not to, walk away from the contract.
To begin with there are two kinds of options; namely, the "Call" option and the "Put" option. Which we shall explain presently.
A Call Option , is an option to buy a stock at a specific price on or before a certain date. In this way, call options are like security deposits. If for example, you want to rent a certain property and left a security deposit for it. The money would be used to insure that you could in fact rent the property at the price agreed upon when you returned. However, if you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises.
When you buy a Call option, the price you pay for it called the option premium, secures your right to buy that certain underlying stock at a specified price called the strike price on or before a specified date. If you decide not to use the option to buy the stock and you are not obliged to, your only cost is the option premium.
A Put Option, is an option to sell a stock at a specific price on or before a certain date. In this way, put options are like insurance policies.
Let's say you buy a car, and then buy auto insurance for the car. You pay a premium to the insurance company, and are hence protected if the asset is damaged in an accident. If this accident were to happen, you can use your insurance policy to regain the insured value of the car. If all goes well and the insurance is not needed, the insurance company keeps your premium amount in return for taking on the risk of damage or loss. In similar fashion, the Put option gains in value as the value of the underlying instrument decreases. With the Put option, the investor can "insure" a stock by fixing a selling price. If adverse market action causes the stock price to fall, thereby causing damage to the asset. Then, the investor can exercise the put option and sell it at its "insured" price level. Thereby causing the underlying asset to regain its value. If on the other hand the price of your stock goes up due to favorable market action, then there is no damage to the asset. Then you the investor do not need to use the insurance. And once again, your only cost is the option premium paid by you.
Thus, the primary function of listed options is to allow investors ways and means to manage market risk.
Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. And the seller accepts an obligation for which he receives a fees.
For a better understanding of options, we would suggest that the investor read about role of options and futures ; types of 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.