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Saturday, 13 January 2018

"Options" instrument in Stock Market

Options are another part of F&O instrument in Equity Market along with Futures. The biggest difference between a Future contract and an Option contract is that in case of Future Contract it is mandatory to abide by the contract for both Future contract buyer and seller but in case of Options (as name also suggests) it is mandatory for seller to abide by the contract but buyer can opt out of contract.

Options are like health insurance where buyers pay premium to protect themselves if things go wrong and seller receives premium thinking that things won’t go wrong. An option buyer is like a common person who takes health insurance from a company by paying some premium and option seller is like an insurance provider that takes premium to help you out in future if things go wrong with your health. In terms of market, option buyer wants to protect himself from volatile movement of either market going up or going down in big way and option seller is ready to take that risk for some money called premium.

Put Option:

In Put option, buyers try to protect themselves from price of a stocks going down and sellers take that risk just by taking some money as premium.

Let’s assume that you are thinking that Infosys stock is likely to go down in coming days due to some USA news or some negative result. Infosys is currently at 900 Rs and you think it might go down by 10-11% to 800.  Now as per human tendency there is someone else who thinks that no Infosys won’t go down much in this scenario. In this case Option buyer buys a PUT option of INFY 900 by paying some money to seller, say 10 Rs. As F&O happens in lot sizes only, in this case buyer has paid 10 Rs/Share to seller as premium.

Case 1: INFY goes down to 800 Rs after news, in this case put option buyer will make big money. The buyer’s profit will be:

Put option price (900) – Premium Paid to seller (10) - Current Price (800) = 90 Rs per share

Seller’s loss will be:

Current Price (800) + Premium received from Buyer (10) - Put option price (900) = 90 Rs per share

Case 2: INFY goes down to 890 Rs after news, this will be a breakeven case for both buyer and seller.

Case 3: INFY stays at 900 Rs after news, in this case buyer will lose the 
premium he paid that is 10 Rs/ Share as INFY didn’t go down from his contract buy price of 900 and hence seller will make 10 Rs/Share profit.

Case 4: INFY goes up to 920 Rs after news, in this case buyer will lose the premium he paid that is 10 Rs/ Share as INFY didn’t go down from his contract buy price of 900 and hence seller will make 10 Rs/Share profit.


Call Option:

In Call option, buyers assume that price of stock will go up in coming days and sellers think that it won’t go up too much so sellers take that risk of upward movement just by taking some premium.

Let’s assume that you are thinking that Infosys stock is likely to go up in coming days due to some USA news or some positive result. Infosys is currently at 900 Rs and you think it might go up by 10-11% to 1000 Rs. Now as per human tendency there is someone else who thinks that no, Infosys won’t go up much in this scenario. In this case Option buyer buys a CALL option of INFY 900 by paying some money to seller, say 10 Rs. As F&O happens in lot sizes only, in this case buyer has paid 10 Rs/Share to seller as premium.

Case 1: INFY goes up to 990 Rs after news, in this case buyer will make big money. The buyer’s profit will be:

Current Price (1000) - Premium Paid (10) - Call option price (900)   = 90 Rs per share

Seller’s loss will be:

Call Option Price (900) + Premium received from Buyer (10) – Current Price (1000) = 90 Rs per share

Case 2: INFY goes up to 910 Rs after news, this will be a breakeven case for both buyer and seller.

Case 3: INFY stays at 900 Rs after news, in this case buyer will lose the premium he paid that is 10 Rs/ Share as INFY didn’t go up from his contract buy price of 900 and hence seller will make 10 Rs/Share profit.

Case 4: INFY goes down from 900 Rs after news, in this case buyer will lose the premium he paid that is 10 Rs/ Share as INFY didn’t go up from contract buy price of 900 and hence seller will make 10 Rs/Share profit.

As we can see in both cases Seller is making maximum profit of 10 Rs/share that is the premium paid by buyer whereas buyer can make any money with risk of just losing 10 Rs/ share at max. Now this does sound a good less risky deal, no? But as per market studies in many countries Option sellers make much more money than buyers just because occurrence of their successful trade is much higher as compare to them going wrong. One of the most important factor for this is the time decay. As all these Contracts are bound by timelines, buyers need to be right on time factor as well as Price movement whereas sellers just need to be right on Price movement. In the examples discussed above in Case 1 buyer won’t make that profit if INFY’s price goes down to 800 or up to 1000 after contract end date which is usually the last Thursday of every month for Indian market.

All big funds and investment banks use Put Option mostly to hedge their stock holdings to avoid big losses in case stock prices goes down due to any negative sentiment. In Indian capital market Options are highly traded for Index NIFTY and BANK NIFTY.