Options are a financial instrument which offers an investor the right to either buy or sell an underlying asset at a price agreed upon by the buyer and seller at a predetermined date. Option does not create an obligation on the buyer or the seller and can be exercised at their own will. This freedom to exercise the right at one’s discretion comes at a cost known as ‘premium’. The price at which the contract is called upon is the ‘strike price’.
The premium is a non-refundable upfront deposit which gives the trader the right:
- Right to buy a security at a certain strike price is known as a Call Option.
- Right to sell a security at a certain strike price is known as a Put Option.
Options are usually used by investors to leverage or hedge their positions. They can help investor protect one’s portfolio in a volatile market but the process of trading in options is very complex compared to trading in normal cash segment. It involves good understanding of trading and investment philosophy and constant monitoring of the fluctuations in the stock prices.
An example of Nifty Call option
Mr. A buys Nifty 11,500 call expiring 27 December 2018 at Rs. 100 a share, with 75 shares making a lot. Nifty expired at 11,750 making the option in the money Rs. 150 (after deducting the premium paid by buyer). In this case the seller is obliged to sell Nifty to buyer at 11,500 even when the index is 11,750. End result is the buyer makes a gross profit of Rs. 150 per share or Rs. 11,250.
In the above case, if Nifty would have expired at 11,300, the buyer would have not exercised the call, as it is out-of-money (he would end up with loss on execution). On expiry date, Nifty is settled in cash by the buyer and the seller.
Option Buyer is the holder of the ‘Call Option’ which gives the right to the buyer to buy the underlying asset at the strike price on or before the expiration date. They are usually the traders who believe that the stock price will rise above the strike price plus the premium paid.
The Option Buyer can also hold ‘Put Option’ which is the right to sell the shares at a strike price on or before the expiration date. Option buyers believe that the stock price will fall below the strike price and the premium amount paid. In cases where the stock prices rises in opposition of their expectations, these Put Option traders will only lose the amount paid as a premium, restricting the loss.
Option Seller is the person who sells the call or put option. They take an obligation to sell the underlying asset to the buyer at a predetermined rate, only if the buyer wishes to exercise his option. There are usually two forms of Option Sellers:
- Covered Calls: In this case, the option seller owns the underlying asset. The investor is basically selling the right to an equity already owned by him. If the buyer of the option decides to exercise his right, then the seller will have to sell the stock at the predetermined strike price.
- Naked / Uncovered Calls: In this case, the Option seller or the Option writer does not own any shares of the stock which is linked to the option. This strategy involves huge risk and is pure speculation. It can also be the most profitable, if the stock price does not breach the strike price in the specified period, these option sellers earn huge premiums.