Sunday, February 24, 2013

Exchange Traded Derivatives - OPTIONS

Option Contract :

In this post I ll explain basic concepts of options. In financial market Options are contracts like forward and futures with some more flexibility. As we have seen in case of futures two parties go in a contract to carry out a trade on some future date.In this type of contract parties are oblized to fulfil the contract and one party is always going to benefit from the trade so trade always takes place.
In options contract the party 'buying' the contract has an option to exercise the contract or to let it go unexercised. At the time of expiry of contract ( depending on wether its European type or American type. I ll explain about it a bit later. ) if option buyer thinks that he is going to get benefit from this trade then he can choose to exercise the contrct but if he finds that the trade is not profitable for him then he ll ignore that.


Let's consider the same example of  murari lal and ramdin again. Murari lal who is an owner of a flour mill wants to buy wheat from Ramdin who is a former in nearby village. This is month of january and wheat in market is being traded at INR28 per kg.Murari Lal expects this price to go up to INR30 /kg in march but he wants to buy it in  march at a price of INR28 per kg only.
Ramdin who is a former expects wheat prices to go down to INR25/kg due to arrival of new crop.
Murari lal agrees to pay INR1/ kg now if Ramdin agrees to supply him heat at coast of INR28 /kg irrespectie of the market price at that time. So at this time murarilal pays INR 100 to Ramdin to buy 100 kg of wheat on 25 march at peice of INR28 per kg.
Now on 25 march We may have following scenarios:
1) wheat is trading at INR25 per kg in market. in this case Murari lal will prefer to buy wheat from market and he ll not buy it from Ram din according to the contract. becase according to the contract he ll have to pay INR 2800 for 100 kg while he can get the same quantity in INR 2500 from market.
In this case Murari lal has a lose of INR 100 which he paid initially to buy this contract.

2) Wheat is trading at INR28 / kg in market. In this case Murari lal may or may not  fulfil the contract in any case he ll lose his INR100 that he initially paid. He ll have to pay INR 2800 wether he buys it from ramdin or from market.

3) Wheat is trading at INR28.50 /kg. In this case Murari lal must exercise the contract. ie his right to buy. In market he ll have to pay INR 2850 if he buys 100 kg wheat.  if he buys it from Ram din according to contract then he ll have to pay INR 2800 only.
So in this case murari lal has a profit of INR 50 on trade but he already has paid INR 100 for contract so still he is in loss of INR 50 but this is less than what he would have if he doesn't exercise the contract.

4). Wheat is trading 1t INR 29 /kg in market.  in this case Murari lal will exercise the contract and he ll make a profit of INR 100.Since he is paying INR2800 if he exercises the contract. If he buys the same quantity from market then he ll have to pay INR 2900.
In this trade he doesn't have any profit or loss over all because he paid INR100 for contract.

5) Wheat is trading at INR 32 /kg in  market. in this case On fulfillment of contract murari lal will have a profit of INR 400 on trade. If we subtract INR 100 that he paid for contract then over all profit on this trade is INR300w.

As it is clear from above discussion loss of Murari lal is limited to INR 100 even in case of  the sharpest decline in wheat price. Even if wheat is trading at INR 1/kg he ll simply not buy it from Ramdin and maximum he ll loose is INR 100.

But in case of sharpest rise of price due to some event his profit is unlimited. say if wheat price goest to INR 50/kg his profit will go to INR 2100.

 From example above Follwoing are some standard terms that are used in Options market.

Options Contract : The Type of contract in which buyer has an option to exercise contract. Like in above example murari lal has baught an option to buy het on 25 th march at Rs 28/kg in 1 Rs/kg. He no has a right to excercise this contract  if he wishes to do so.

Strike Price :  Or just strike. It is the price on which the product will be traded according to the contract. for example in above case Rs 28 in which wheat will be purchased  is strike price because this is the agreed price for which contract is done.

Contract Expiry/Maturity Date : This is the date on which contract expires. If it is has to be exercised then it must be done on or before this date. In american type of contracts the option can be exercised on any date before this date. In European types of contract this can be done only on expiry Date.

Option Premium: This is the amount which is paid for buying options. In example above option premium paid was Rs 100 for 100 kg of heat.

Lot size :  Usually options are traded in lot of multiple quantities. For example in above case murari las to pay premium for 100 kg of heat. IF e consider 1 kg of wheat as one unit and we always trade in multipe of 100 kg then lot size ould be 100.

Spot Price :  This is market price of product at any given point of time. Like if it is 27th of february today and wheat is trading at 26 Rs /kg then spot price ould be 26 Rs. as we saw skrike price is Rs 28 for above contract.

In Money Option :  If at any point of time (before expiry ) a contrat is making money. ie it were to exercise
at that time and it could be profitable then it is called in money option.

In above example as we swa murari lal is going to exercise his option  at a price more than Rs. 28 i e strike price.So for above examplew at any point of time when market price is more than strike price then contract is said to be in money contract.
Out of money contract : Similarly if for above contract at any point of time wwmarket price of product is lower than its strike price then option wwiwll be wout of money option.

Type Of Options (Put and Call) :

In the example above where murari lal baught an option of buying 100kg of wheat at price of 28 Rs/kg , murari lal actually baught a call option.
A call option is an option in which buyer of contract has a right to buy underlying. Underlying may be anything in example above the underlying is wheat. similarly it an be metal, oil, stock , currency or even index.
Similarly Ram Din who wants to sell hie wheat crop maybe interested in selling his crop on a certain price.
in that cse he 'd like to buy a put option. Buying a put
option gives you a right to sell underlying on a certain price.

So anyone expecting a fall in price of underlying buys a put option so that he can sell it even if its market price goes below the strike price of underlying.

From above discussion its clear that put option buyer is bearish in nature. i.e. he expects market to go down to make money. on other hand a call option buyer is bullish in his approach i.e. he expects market to go up to make some profit.

Like buying of these options you can also sell these options to give someone a right to buy or sell.
you can sell a put contract to give someone a right to sell certain quantity of some underlying to you. If market price of underlying goes below the strike price then buyer ll exercise his option.If you are a put  option seller then you ll expect price of underlying to go up. if it does not go below strike price then your profit is option primium that you received initially while selling the option.

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