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OPTIONS contract in STOCK MARKET


Option derivatives are most significant part of derivative markets , not only in India but in the whole world. As of Zerodha’s Varsity, nearly 80% of derivatives traded are the option derivatives and rest of them are traded as futures. This fact adds to the crerdibility and trust on options . Their should be a rock-strong reason for it’s large numerical dominance over future markets. This dominance comes from the unique features and the greater extent of security which it provides . Yes, we can say that options are very much secure than other derivatives. So, why are derivatives more secure than that of future markets? We will discuss all this here :

Options are traded in the Indian markets for over 15 years, but the real liquidity was available only since 2006
An Option is a tool for protecting your position and reducing risk
A buyer of the call option has the right and the seller has an obligation to make delivery
The option is only given to one party in the transaction ( buyer of an option)
The option seller is also called the option writer
At the time of agreement the option buyer pays a certain amount to the option seller, this is called the ‘Premium’ amount
The agreement happens at a pre specified price, often called the ‘Strike Price’

Consider the situation ; there is a person named Hardik. Hardik wants to buy a new car. He goes to a car showroom and he likes the particular model of car valuing Rs.10 Lakh. Meanwhile, there are rumours moving on in the country that central government is going to change the GST rates in automobile sector. It is not clear whether it will increase or decrease. It also have equal probability that the news is the fake one. This situation puts Mr. Hardik in dilemma:
i) If he wait for some time to buy the car and GST gets increased, the car would cost him more than10 Lakh.
ii) If he buy the car at the very moment and the GST gets reduced by a significant amount after some time, the price of car would be much less than 10 Lakh . This case will also not make him happy as he lost the chance to save a good amount of money.
Mr. Hardik is in confusion here about what to do?Meanwhile, the seller gives him an offer that Hardik can submit a non-refundable amount of Rs. 20,000 and book the car after some time. If the price of car changes to any extent, whether increase or decrease, he will be able to buy the car 10 Lakh. Let say it becomes Rs. 10,50,000 , then also, he can buy the car for Rs. 10 lakh. If the price of car fall to Rs.9,50,000 , he may or may not buy the car. It will be the buyers choice but that amount of Rs.20,000 will not be returned.
NOTE : i)The non-refundable booking charge of Rs. 20,000 will not be adjusted with the buying of car. If Mr. Hardik Buys this car for Rs. 10,20,000 . If he decides not to buy the car, than also this deal will cost him Rs. 20,000 .
ii)Here, Mr. Hardik have choice to choose whether to buy or not to buy the car as he is not obliged by the agreement, but the seller do not enjoy this option to not sell the car if he want to do so. If Hardik wants to buy that car, seller will have to sell it .This is what for which the non-refundable fee was paid by the buyer .

Here, we have just discussed the basic idea of option trading and its benefit in risk-management.

CASE 1 – If the GST decreases:

Part 1 ( decrease in price is greater than Rs.20,000 ; our non-refundable fee)
Suppose if the price of car decrease and becomes Rs. 9,50,000 . In this case, as Mr. Hardik had paid Rs.20,000 , but he is not obliged to buy the car for Rs. 10 lakh as of the conditions laid in the agreement . Now he can buy the car for Rs. 9,50,000 by letting his Rs.20,000 go in vain. So the total value paid becomes Rs.9,50,000 +Rs. 20,000 = Rs. 9,70,000 which is Rs. 30,000 less than Rs. 10 Lakh .
Part 1 ( decrease in price is less than Rs.20,000 ; our non-refundable fee)
Suppose that the price of car decrease but only by Rs. 10,000 and now it becomes worth Rs.9,90,000 .So, the total value invested here would be Rs.9,90,000 +Rs. 20,000 = Rs. 10,10,000 which is 10 thousand more than the money for which he would have paid to buy the car some days before.

CASE 1 – If the GST increases:

Now imagine the case if price of car becomes Rs. 10,50,000 . Here in this case , car value Rs.10 Lakh 50 thousand ,but due to the agreement made between buyer and seller, Hardik can now buy the car for Rs.10 lakh and saves a good amount of money.
OBSERVATION
Here in the all cases discussed, we observed that the maximum loss that Mr. Hardik can face is Rs.20,000 which he paid as the non-refundable fee. We can relate this situation to the insurance companies as well.
What we have discussed above is an example of Call Option . Take Mr. Hardik as you, car as the stocks and the car seller as the seller of stocks i.e. brokerage firm like zerodha or upstox. You must have got the above example very well, let us discuss the call and put options and difference between them.
First of all, let us discuss some basic terms which are used very often while discussing option derivatives :
Here are a few major terms that we will look into –
  1. Strike Price
  2. Underlying Price
  3. Exercising of an option contract
  4. Option Expiry
  5. Option Premium
  6. Option Settlement

Strike price

Consider the strike price as the anchor price at which the two parties (buyer and seller) agree to enter into an options agreement. As in the example of Mr. Hardik and car seller, seller agrees to sell the car at a fixed price of 10 Lakh. This price of 10 lakh on which the deal has been signed is called as the strike price . For all ‘Call’ options the strike price represents the price at which the stock can be bought on the expiry day. The price which we decide to buy or sell a particular stock on it’s expiry is known as it’s strike price.

Underlying Price

As we have discussed this in derivatives section, a derivative contract derives its value from an underlying asset .The underlying asset in stock market are the stocks of a company. The underlying price is the price at which the underlying asset trades in the spot market. So, if you are buying the option contract of AVANTI FEED, than the price at which stocks of AVANTI FEED are trading in the spot market is known the underlying price for the option of AVANTI FEEDS.

Exercising of an option contract

Exercising of an option contract is the act of claiming your right to buy the options contract at the end of the expiry.As web have discussed above in the example of car buying, when Mr. Hardik use his right of buying the car at 10 lakh even if the price of car reach Rs11 Lakh, this is known as Exercising of an option contract .

Option Expiry

Similar to a futures contract, options contract also has expiry. In fact both equity futures and option contracts expire on the last Thursday of every month. Just like futures contracts, option contracts also have the concept of near month, next month, and far month.
The day on which option or future contract expires, this is last day when may get the delivery of stocks ( for which option contracts were signed, if you didn’t get it , you probably are not aware much about the basic concept of derivatives) . If we consider the above example of car, seller can not let Mr. Hardik to buy the car for 10Lakh. The agreement is signed for a fixed period of time like 1 month ,2months etc.

Option Premium

The non-refundable fee of Rs. 20,000 that Mr. Hardik paid to the car seller to get a right to buy the car for Rs.10lakh even after two months is known as the premium. The maximum loss that you can face in option trading is losing your premium. If you are at profit in you trade, than you can buy the car using that contract but if you face more loss than that of your premium, than you can let the contract go in vain and try any other car but as that premium is non-refundable, you face a loss of Rs. 20,000 .

Option Settlement

The options contract settlement is the process to resolve the terms of an option contract between the relevant two parties when it is exercised .The exercising of option can be done on or before the expiry date of the contract.
Although settlement is technically between the holder of options contracts and the writer of those contracts, the process is actually handled by a clearing organization ( SEBI and your stock broker). When the holder exercises, or an option is automatically exercised, it's the clearing organization that effectively resolves the contracts with the holder.

CALL & PUT OPTIONS

Call Option

The example of car that we discussed above was an example of call option. Let us now attempt to extrapolate the same example in the stock market context with an intention to understand the ‘Call Option’. Do note, I will deliberately skip the nitty-gritty of an option trade at this stage. The idea is to understand the bare bone structure of the call option contract.
Assume a stock is trading at Rs.67/- today. You are given a right today to buy the same one month later, at say Rs. 75/-, but only if the share price on that day is more than Rs. 75, would you buy it?. Obviously you would, as this means to say that after 1 month even if the share is trading at 85, you can still get to buy it at Rs.75! In order to get this right you are required to pay a small amount today, say Rs.5.0/-. If the share price moves above Rs. 75, you can exercise your right and buy the shares at Rs. 75/-. If the share price stays at or below Rs. 75/- you do not exercise your right and you do not need to buy the shares. All you lose is Rs. 5/- in this case. An arrangement of this sort is called Option Contract, a ‘Call Option’ to be precise. After you get into this agreement, there are only three possibilities that can occur. And they are-
  1. The stock price can go up, say Rs.85/- :
  2. The stock price can go down, say Rs.65/- : If the stock price goes down to say Rs.65/- obviously it does not makes sense to buy it at Rs.75/- as effectively you would spending Rs.80/- (75+5) for a stock that’s available at Rs.65/- in the open market.
  3. The stock price can stay at Rs.75/- : Likewise if the stock stays flat at Rs.75/- it simply means you are spending Rs.80/- to buy a stock which is available at Rs.75/-, hence you would not invoke your right to buy the stock at Rs.75/-.

Put Option










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