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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.

Wednesday 1 November 2017

What is "Future and Options" in Stock Market

Many of the people who get into Equity market aka Stock Market directly only deal with one part of it called “Cash Market”, a market where one can buy and sell shares from quantity 1 to many depending on money one has. There is another part of Equity market called “Future and Options” abbreviated as F&O.

What is F&O :

F&O is Contract based trading instrument which has validity from 7 days to 90 days depending on whether it is for INDEX like NIFTY / BANK NIFTY or individual stocks. In this there is no transaction of shares until the last day of contract and there is just agreement made between Buyers and Seller to abide by contract price and date. The Price in Cash market and Price and various data points in F&O market affect each other.

Future:

Future instrument is a contract between buyer and seller about Future price of a stock or Index. In Indian market Future Contracts are of one month expiring on last Thursday of every month and the new contract starting just a day after that. One can buy individual contract of next 3 months as only 3 Contracts can be active at one time for any stock or Index. Basic component of Contract are Stock name, Future agreed Price and expiry date. So INFY 26 OCT17 FUT means Future contract of Infosys for October month expiring on 26th October 2017.

If one buys Future contract of INFY for October month, buyer is agreeing to buy INFY at price mentioned in future market, at max by last day of contract expiry which is 26th October. Suppose Current Market price of INFY is 900, and October’s Future Price is 920 (because market sentiment is positive), so buyer is agreeing to buy INFY at 920 Rs maximum by 26th October, no matter whether stock price goes down or up.  If stock prices goes to 950 Rs in that month, buyer will make profit because buyer has right to buy same stock at 920 Rs as per contract. If stock price goes down to 880, buyer will lose money because as per the agreement buyer promised to buy INFY at 920 Rs. and vice versa the contract seller will make profit and loss. There can be one more case when INFY stays around 900-905 Rs for whole month and closes at 900 on last day, in this case also buyer will lose money because buyer needs to buy INFY at 920 Rs whereas the market price is 900 Rs and hence contract seller will make profit. 

Now to summarize profit and loss cases for Futures:

Buyer will make money only when stock price moves up from price of future agreement in the Contract month

Seller will make money when stock prices goes down in the Contract Month

Seller will make money when stock prices stays same in the Contract Month

Seller will make money even if stock price goes up by any percentage but after contract expiry date.

As one can see that timing also is one big factor in Future market unlike in Cash market and Buyer and Seller need to be precise enough to make full use of this instrument of stock market. Unlike in Cash market, these Contracts are done in lots and one lot contains many shares, so to be able to use these contracts one needs to have enough capital and margin in their account. The Advantage of it is that brokerage firms let their clients use Margin money to buy or sell Future Contracts and no need to have full money in your account. To give an idea of this, to buy 500 Shares of INFY in Cash Market one needs to have 4,50,000 Rs (500 x 900) in account but to buy same in Future one needs 10% to 50% of total money in account depending on Brokers they are taking service from.

As Options are too big to explain in this post and has two part as “Call” and “Put”, I will be posting it soon as new post :)