An analogy of an option
To explain an option on a lighter note, let’s say you book tickets for a particular movie in advance. You have bought the right to view the movie but are not under any obligation to do so. You could either exercise your right to view the movie on the appointed date at the appointed time or you simply sell off your tickets, for a higher or lower price, depending on the demand for the movie. Lastly, you may just decide to let your tickets go waste and not show up for the show at all. On the flip side, the person who sells an option can be compared to the theatre owners. Once they have sold movie tickets to you, they are obliged to show you the movie. This is broadly how options in the capital market work too, but at a slightly more complex level since there are a variety of options available, which are suitable for different market conditions and can be chosen on the basis of your expectations and risk profile.
Call and Put Options
On the basis of whether you want the option to buy shares or sell them at a specific price in the future, there are two types of options available in the derivatives markets. They are called the ‘Call option’ and the ‘Put option’. The former givesyou the right to buy shares or an index whereas the latter givesyou the right to sell them, with no obligation. Let’s take a look at these two options, one at a time.
When you purchase a ‘call option’, you purchase the right to buy a certain number of shares or an index, at a predetermined price (strike or exercise price), on or before a specific date in the future (expiry date). In exchange for this facility, you have to pay an option premium to the seller/writer of the option. This is because the writer of the option assumes the risk that the market price will rise beyond your strike price on or before the expiry date of your contract and he will be obliged to sell you shares at the strike price, although it means making a loss. The premium payable isa small amount that is also market driven.
Illustration of a Call Option on an index
As a trader, you would choose to purchase an index option if you have a view on the price movement of the index rather than any expectation about the price movement of a particular share. Indices on which you can trade include the S&P Nifty CNX 50, CNX IT and Bank Nifty on the NSE and the Sensex on the BSE.
Suppose the Nifty is quoting around 3000 points today. If you are bullish about the market and foresee this index reaching the 3100 mark within the next one month, you may buy a one month Nifty call at 3100. Let’s say that this call is available at a premium of Rs 30 per share. Sincethe current contract size of the I\lifty is 100 units, you will have to pay a total premium of Rs 3000 to purchase one call option on the index.
If the index remains below 3100 points for the whole of the next month, until the contract expires, you would certainly not want to purchase it at 3100 levels. And you have no obligation to purchase it either. You could simply ignore the contract and all you have lost is your premium of Rs 3000.
If, on the other hand, the index does cross 3100 points, as you expected, you have the right to buy at 3100 levels. Naturally, you would like to exercise your call option. But remember that you will start making profits only once the Nifty crosses 3130 levels, since you must add the cost that you have incurred by paying the premium to the cost of the index. This is called your break even point a point where you make no profits and no losses. When the index is anywhere between 3100 and 3130 points, you begin to recover your premium cost, so it still makes sense to exercise your option at these levels, if you do not expect the index to rise further or the contract reaches its expiry date at these levels.
Now, let’s look at how the writer of this option is fairing. As long as the index does not cross 3100 and you do not exercise the option, he benefits from the option premium that he has received from you. If you exercise your option when the index is between 3100 and 3130, he is forced to part with some of the premium that you have paid him. Once the index is above 3130 and you exercise your option, his losses are equal in proportion to your gains and both depend upon how much the index rises.
In a nutshell, the option writer has taken on the risk of a rise in the index for a sum of Rs 30 per share. Further, while your losses are limited to the premium that you pay and your profit potential is unlimited, the writer’s profits are limited to the premium and his losses could be unlimited.
Illustration ofa call option on a stock
In the Indian market, options cannot be sold or purchased on any and every stock. SEBI has permitted options trading on only certain stocks that meet its stringent criteria. These stocks are chosen from amongst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis, amongst other technical criteria.
Suppose the AGM of RIL is due to be held shortly and you believe that an important announcement will be made at the AGM. While the share is currently quoting at Rs 950, you feel that this announcement will drive the price upwards, beyond Rs 950. However, you are reluctant to purchase Reliance in the cash market as it involves too large an investment and you would rather not purchase it in the futures market as futures leave you open to an unlimited risk, in case the market goes against you. Yet you do not want to lose the opportunity to benefit from this rise in price due to the announcement and you are ready to stake a small sum of money to rid yourself of the uncertainty. An option is ideal for you. Depending on what is available in the options market, you may be able to buy a call option of Reliance at a strike price of 970, although the spot price is Rs 950 at present, by paying a premium of Rs 10 per share. The total premium that you will have to pay is Rs 6,000, since one contract of Reliance consists of 600 shares.
You start making profits once the price of Reliance in the cash market crosses Rs 980 per share (i.e., your strike price of Rs 970 + premium paid of Rs 10).
Now let’s take a look at how your investment performs under various scenarios. If the AGM does not result in any spectacular announcements and the share price remains static at Rs 950 or drifts lower to Rs 930 because market players are disappointed, you could allow the call option on Reliance to lapse. In this case, your loss would be Rs 10 per share, amounting to a total of Rs 6,000. However, things could have been worse if you had purchased the same shares in the cash market or in the futures segment.
On the other hand, if the company makes an important announcement, it would result in a good amount of buying and the share price may move to Rs 1,000. You would stand to gain Rs 20 per share, i.e., Rs 1,000 less Rs 980 (strike price of Rs 970 + premium of Rs 10), which was your cost per share.
As in the case of the index call option, the writer of these options would stand to gain only when you lose and vice versa, and to the same extent as your gain/loss.
Index Levels Payoff for the Index Call Purchaser Payoff for the Index Call Writer Below 3100 levels Call purchaser loses the premium The premium is the option writer’s income Losses start for the option writer The option writer also breaks even The option writer loses part of the premium Profit starts for the call owner Call purchaser breaks even Call purchaser recovers part of the premium element but still making an overall loss Between 3100 and 3130 levels Above 3130 levels At 3130 levels "
Below Rs 970 Call purchaser loses the premium Payoff for the Reliance Call Seller at Strike Price of Rs970 Option writer makes lossesthat are equivalent to the call owner’s profits The option writer also breaks even The premium is the option writer’s income The option writer loses part of the premium Payoff for the Reliance Call Purchaser at Strike Price of Rs970 At Rs 980 Call purchaser exercises the option and breaks even Above Rs 980 Call owner exercises the option and makes profits Price of Reliance Between Rs 970 and Call purchaser recovers part of the Rs 980 premium element but still making an overall loss