Options

An options contract is nothing but the right to buy or sell something at a specified price within a period of time. The feature of the options contract for a buyer is that, the buyer has the right to buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyers maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the options contracts for sellers is an obligation. If a seller enters into an agreement, he has to deliver the asset on the specified date and the price agreed upon. Thus the loss for a seller could be much worse.

Terminologies
1. CALL and PUT
The right to buy is called a "CALL" option while the right to sell is called a "PUT" option.
right to buy - CALL    (learning bc - buy call)
right to sell - PUT
Please note that an option is only a right to do something. It is not an obligation to carry out the action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.

For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy 1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The total value of the contract would sum up to 10,00,000/- (10 lacs) As part of getting into the contract you make an initial payment of say 2% of the contract value to the merchant. You make a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the buyer and the merchant is the seller.

Change of Price of Asset
Now take the above example on gold. 
1. Assuming on 1st December the price of gold is Rs. 1050/- per gram, then to buy thousand grams of gold you would need Rs. 10,50,000/- rupees which is Rs. 50,000/- more than your options contract. Hence if you exercise your right to buy, you stand to make a profit of Rs. 50,000/- At the same time, the seller has an obligation since he has agreed on the contract and he has to sell the gold to you at a loss of Rs. 50,000/- when compared to the market rate.

2. Assuming on 1st December the price of gold is Rs. 950/- per gram, then to buy thousand grams of gold you would need Rs. 9,50,000/- which is Rs. 50,000/- less than your options contract. Hence if you exercise your right to buy, you stand to lose Rs. 50,000/- You can buy the same quantity of gold in the market at a lesser price. Hence you can choose to let your contract expire and limit your losses to only Rs. 20,000/- The Seller on the other hand does not make any transaction but still stands to keep the Rs. 20,000/- you paid him to form the contract.

In above example 1 thing is clear, that why option is called derivative because option is a contract that deals with an underlying asset like gold, property, stock the value of which changes.
Another point we get is when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment (the initial one), which is the money you used to pay for the option.

The initial 2% charged is because the buyer don't give full money to the seller in advance. This is like interest or security.

2. STRIKE / EXERCISE PRICE, OPTION PREMIUM, EXPIRY DATE, SERIES
This 1000 rupees per gram that you agreed upon with the merchant is called the "STRIKE OR EXERCISE" Price.
The initial deposit of Rs. 20,000/- you paid him is called the "Option premium".
EXPIRY OR EXPIRATION MONTH  = when the option contract terminates
SERIES = expiration month and exercise price
We will cover more terminology as we go through this tutorial.

Partcipants in an Options market:
1. Buyers of Calls
2. Sellers of Calls
3. Buyers of Puts
4. Sellers of Puts

People who buy options are called "HOLDERS" and    (learning way bh of bhu )
those who sell options are called "WRITERS"

Eg. in case of stock market.
Buyers of calls hope that the stock will increase substantially before the option expires. Buyers of puts hope that the price of the stock will fall before the option expires.
Call Holders and Put Holders (The Buyers) are not obligated to buy or sell. They have the right to do so if they wish. Similarly Call writers and Put Writers (The Sellers) are obliged to buy or sell. This means that they need to buy or sell if the Call holder decides to exercise his right to buy.

Characteristics of Options Contracts:
1. Unlike other derivative products that are price fixing contracts, options are price insurance type of contracts
2. Options have been basically OTC products. But of late, due to its popularity, exchange traded options are also being widely used.
3. The options are very favourable to the Holders or the Buyers.

Widely used terms in Options contracts:
In-the-Money - An ITM option is one that would lead to a positive cash flow to the holder if it were exercised immediately. For e.g., If you have an options contract to buy shares of XYZ limited at Rs. 100/- per share and it is currently trading at Rs. 120/- per share then your options contract is said to be In the Money.

At-the-Money - An ATM option is when the prevailing price of the asset and your option price are more or less same.

Out-of-the-Money - An OTM option is when the prevailing price of the asset is lesser than the option price.

An Example call Option with respect to the Share Market:

You buy 10 call options for the company XYZ pvt ltd, at the strike price of Rs. 325/- at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.

Two things can happen here:

1. You can make a profit:
Say on the date of expiry the share of XYZ pvt ltd is trading at Rs. 380/- per share, then you can opt to exercise your call option. Hence you would be getting 10 shares of XYZ ltd at Rs. 325/- which you can sell at Rs. 380/-

Your Input cost per share = 325
Premium per share = 10
Market value during Selling = 380

Your Profit per share = 380 - (325+10) = Rs. 45 /-

Net Profit = Rs. 450/-

Here Rs. 325 is the Strike price and Rs. 380 is the spot price.

2. You can incur a Loss:
Say on the date of expiry the shares of XYZ pvt ltd is trading at Rs. 275/- per share, then you can opt to let the contract expire. Since you are the buyer or the call holder you can opt to either buy or let the contract expire. Since the share is available in the market at a lesser price than the strike price, it is not wise to exercise the option. Hence you ignore it.

Your input cost = Rs. 10/- (The premium you paid per option)

Loss incurred = Rs. 100/- (Because you do not make any other payment apart from the premium)

Loss you would have incurred if you had exercised the option:

Cost per share = 325
Premium per share = 10

Market value during selling = 280

Your loss per share = (325+10) - 280 = Rs. 55/-

Net Loss: Rs. 550/-

Incurring a loss of Rs. 100/- is better than incurring a loss of Rs. 550/- hence your decision of letting the contract expire was a wise decision.


An Example Put Option with respect to the Share Market:
You buy 10 put options for the company XYZ pvt ltd, at the strike price of Rs. 300 per share at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.

Two things can happen here:

1. You can make a profit:
Say on the date of expiry, the shares of XYZ is trading at Rs. 265/- per share, then you can opt to exercise your contract. You can buy 10 shares of XYZ from the market and then sell your shares to the option writer since he has an obligation to buy if you intend to sell.

Your premium = 10
Your input cost per share = 265

Price at which the Put option is exercise = 300

Profit per share = 300 - (265 + 10) = 25

Net Profit = Rs. 250/-

2. You can make a Loss:
Say on the date of expiry, the shares of XYZ is trading at Rs. 325/- per share, then you can opt to let the contract expire. Since the share is trading at a price more than the option price, you can choose to let the contract expire.

Your premium = 10

Loss incurred = Rs. 100/- (The premium paid)

Even in this case, this loss would be compensated by the fact that you can sell off the shares that you have in the market at a higher price than the option strike price.

Effect of markets
ETD markets 
Options specification and nomenclature is set by the exchange at the time of listing. In the case of equity options, the specifications are only changed by the corporate actions.
OTC markets (Over the counter)
The terms of OTC options are negotiated between the buyer and the seller and are therefore customized.

# American form = exercisable on any business day during its life
# European form = exercisable only at the end of its life
# Exercise of equity options = physical settlement in trading lots
# Exercise of index options = cash settlement in exchange set lots
# Exercise of currency options = cash settlement in country of underlying currency
# Exercise of interest rate options = deliverable set by exchange