Understanding Options

Hello Everyone,

I welcome you all to this wonderful journey of learning Options. Through this course we aim to tackle the most important facets of Derivatives trading. We are talking about the concept of Options trading. 

But before dwelling into the world of Options trading, let us try to understand the concept of Options with the scenario which we all will be able to relate.

Scenario 1:

Imagine Mr.X has a wedding in his house after Three months and wants to buy gold for the same. However, he is fearful of the fact that the gold price might go up in the future. Therefore, to protect himself from the risk of price fluctuations, he goes to a Jewelry shop, and enters into an agreement with the shop owner whereby he fixes the price for jewelry to be bought three months down the line, at the current price of Gold.

But, you must be wondering as to, what is the incentive here for the Jewelry shop owner to fix the price because he is potentially taking a big price risk. If the price goes up after three months, he'll still have to sell the jewelry at the predetermined price. Here, his incentive is a small fee (i.e. Premium/Token) that he will be charging Mr.X for fixing the price of gold. And this fee here is non-refundable.

Say, three months down the line if the price of gold goes up then Mr. X has the right to buy gold at the pre-decided price. On the other hand, if for some reason if the price of gold comes down then he does not have to exercise his right, i.e. he may choose to buy jewelry at the price of Gold three months down the line. He merely stands to lose his premium/token.

So, in the world of Options trading also, if the price of underlying Asset goes in the desired direction then we can chose to exercise the contract but in case our views are wrong, then we can choose to not honour the contract and the maximum lose which we will incur is the fees which we paid to buy the contract.

Scenario 2: 

Now, let us relate the concept to Stock market. The Stock under consideration here is Reliance Industries. There are two traders (Say A & B) in the market. Trader A is having a bullish view on the shares of Reliance Industries and the current price of one share of Reliance Industries is Rs. 2100. And he wants to express his bullish view by buying large number of shares. He is looking to buy 300 shares (say).

So, to buy these many share he will have to invest nearly Rs. 6,00,000. But he does not have that much cash with him. So, he is looking for alternative methods to express his bullish views on the shares of Reliance Industries. And which is where the derivative instrument of Options trading is used by him to express his bullish view on the market with limited capital. 

So, in the world of options trading, one does not need to buy shares of the company to express his/her bullish view. You can express your bullish view by just buying a Call option of certain strike price (also referred to as the expected target price) by paying token money (premium). 

So, Trader A goes to options market and buys 2200 strike price call option by paying Rs. 40 premium to Trader B (option seller). There are 300 shares in one option contract of Reliance Industries. 

So, total money paid by Trader A to buy one call option contract

      = 300*40

      = Rs. 12000

So, we can understand that the huge difference in the amount of capital required to express similar views in the options market and cash market.  

Now the following scenarios can happen with the shares of Reliance Industries upon expiry.

- Say, if the share price of Reliance Industries goes upto Rs 2300 upon expiry, then in that case, the profit for trader A will be -

      = Rs. (2300-2200)*300

      = Rs. 30,000

So, a return of nearly 250% on the investment (Rs. 12000) made.

- Say, if the share price of Reliance does not go up, then in that case the Trader A just stands to lose the premium which he paid to buy the options contract. So in any case, the maximum loss which the buyer of option will incur is to the tune of premium paid. 

Key Learnings- 

  • Options are derivative instrument that derive their value from the value of the underlying asset.
  • Options are highest traded Financial Derivative instrument.
  • There are two parties involved in options transactions : Option buyer and Option Seller
  • Option trading is done both for hedging and Speculative purpose.