2008-03-09

Trading in Options

An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price.

Parties involved :
While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.

Options are of two types - Calls and Puts options :
1. ‘Calls’ give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.

2. ‘Puts’ give the buyer the right but not the obligation to sell a given quantity of the underlying asset, at a given price on or before a given future date.

Option premium : The premium is the price for acquiring the right to buy or sell. It is price paid by the option buyer to the option seller for acquiring the right to buy or sell.
Who decides the premium amount ?
It is calculated using a complex formula called the Black-Scholes formula.
http://en.wikipedia.org/wiki/Black-Scholes
It considers both intrinsic value and time value of a stock.

Time period : The options calendar always ends on the last Thursday of a month and you can buy/sell options for 'x' no. of months.

Strike price : It is the price of the underlying asset at which the same can be bought or sold if the options buyer excercises his right to buy/sell on or before the time period expiration.

Explaining the options concept with a simple example:
Let's say you have an item 'X' of worth Rs.10, I now give you Re.1 to gain control of 'X' for 1 month. This Re.1 is for you to keep, you never have to return it. Within this 1 month, I can do whatever I want with 'X', including selling it. On the expiry day, I would have the OPTION to give you back 'X', or Rs.10, this is what we were agreed upon. Within this 1 month, if I have sold the cup for Rs.12, on the expiry day, I'd have to give you Rs.10 and I'd keep Rs.2, subtracting that Re.1 I've given to you earlier, I've made 100% in 1 month.

1 comment:

Ritesh. P said...

Seemingly esoteric at the start, I needed some help before I could make the exact interpretation of the above blog.

Given an option to sell things and make profit, this seems to be one of the best OPTION to explore and invest.

An informative topic for we lesser knowns.