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:

Call options
Put options

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 INR 150.00 per share at any time between the current date and the end of August. For this privilege, Raj pays a fee of INR 800.00; that is INR 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 INR 40.00 for a premium of INR 15.00. That is he has purchased the right to buy that underlying share for INR 40.00 by the end of December. If the price of the underlying stock rises above INR 55.00 (that is INR 40.00 + INR 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 INR 15.00 and thus limit his loss to this amount only.

If the Premium = INR 15.00 and the Strike price of the Call Option = INR 40.00, then the Break even point = INR 15.00 + INR 40.00 = INR 55.00. That is to say that the price of the underlying stock would have to rise to INR 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:

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 INR 500.00 X 10 = INR 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 INR 1365.00 - INR 1345 = INR 20.00). Now the market lot of the Nifty contract is 200. So, the trader books a profit of INR 20.00 X 200 = INR 4,000.00 per contract. Now, as he had bought 10 Call Options contracts his total profit would be INR 4,000.00 X 10 = INR 40,000.00.

He had paid INR 5,000.00 towards the premium for buying these Call Options. So he would have earned INR 40,000.00 less INR 5,000.00 which is INR 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 INR 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:

When you expect prices to rise, then you take a long position by buying the Call Option. You are bullish on the underlying security.
When you expect prices to fall, then you take a short position by selling the Call Option. You are bearish on the underlying security.

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 INR 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 INR 20,000.00 (that is INR 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 INR 70.00 on Stock 'X'. By purchasing the put option Raj has the right to sell the stock at INR 70.00, but he has to pay a premium of INR 15.00 for this contract.

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

Spot INR 1,040.00
Jan Put 1050 INR 10.00
Jan Put 1070 INR 30.00

The trader purchases 1000 Wipro Put at Strike price 1070 at Put price of INR 30.00. He pays a Put premium of INR 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 INR 1,070.00 , the Spot price of which is INR 1,020.00. By exercising the Put option he earns INR (1070 - 1020) = INR 50.00 per put, which totals INR 50,000.00. His net income is INR 50,000.00 less INR 30,000.00 (that is the premium paid upfront) = INR 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 INR 30,000.00.

Put Options: Long and Short Positions:

When you expect price to fall, then you take a long position by buying Puts. You are bearish.
When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

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.

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