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.
Example:
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
Ramdin who is a former expects wheat prices to go down to
Murari lal agrees to pay
Now on 25 march We may have following scenarios:
1) wheat is trading at
In this case Murari lal has a lose of
2) Wheat is trading at
3) Wheat is trading at
So in this case murari lal has a profit of
4). Wheat is trading 1t
In this trade he doesn't have any profit or loss over all because he paid
5) Wheat is trading at
As it is clear from above discussion loss of Murari lal is limited to
But in case of sharpest rise of price due to some event his profit is unlimited. say if wheat price goest to
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.