Derivatives – Options contract 

Options can be complex, but breaking them down into relatable scenarios can make them more accessible. 

The first game. 

Imagine a game where you pay Rs. 6,000 for the right to buy 1000 Infosys shares at Rs. 1000. If the price reaches Rs. 1090, you exercise the option and make a profit of Rs. 84,000. If the price falls, you limit your loss to the Rs. 6,000 premium paid. This game illustrates a call option, giving you the right to buy a security at a set price, with limited downside risk and unlimited upside potential. 

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 To summarize:

• You pay a premium of Rs. 6 per share (Rs. 6,000 total) for the right to buy 1000 Infosys shares at Rs. 1000.

• If the price reaches Rs. 1090, you exercise the option and buy the shares at Rs. 1000, then sell them at Rs. 1090, making a profit of Rs. 84,000 (Rs. 90,000 - Rs. 6,000).

• If the price falls, you don't exercise the option and limit your loss to the premium paid (Rs. 6,000).

This game illustrates the basics of a call option:

• Right to buy a security at a set price (strike price)

• Limited downside risk (premium paid)

• Unlimited upside potential

The second game. 

Imagine Infosys shares are trading at Rs. 1000 each. You pay Rs. 6 per share for the right to sell 1000 shares if the price drops to Rs. 910. If the price falls, you can sell the shares at Rs. 910 and limit your loss. If the price rises, you don't lose anything on the 1000 shares. The most you can lose is the Rs. 6,000 you paid to play this game.

If the price does drop to Rs. 910, you can make a profit of Rs. 84,000 (Rs. 90,000 minus Rs. 6,000). But if the price goes up, you'll lose the Rs. 6,000 you paid to play. This game lets you make a limited profit and limits your losses. This game is called a 'Put option'.

This game illustrates the basics of a Put option:

• Right to sell 1000 Infosys shares at Rs. 910 (strike price)

• Premium: Rs. 6 per share (Rs. 6,000 total)

• Limited profit: Rs. 84,000 (if price drops to Rs. 910)

• Limited loss: Rs. 6,000 (if the price rises)

Now let us try to understand this better. 

The first game is called a CALL option and what you did was to buy a call option. 

The second game is called a PUT option and what you did here was to buy a put option. 

To recap:

• A call option gives the holder the right to buy a security at a specified price (strike price).

• A put option gives the holder the right to sell a security at a specified price (strike price).

• The buyer of an option is called the holder.

• Options are bought and sold on a stock exchange.

• If you expect the stock price to rise, you would buy a call option.

• If you expect the stock price to fall, you would buy a put option.

When you buy an option, someone else must sell it to you. These sellers are known as option writers. They have the opposite view of the buyer. For example, if you buy a call option expecting the price to rise, the option writer expects the price to fall.

It might seem logical that if someone expects the price to rise, they would sell a put option or buy a call option, as both actions seem similar. However, that's not the case.

Both buying a call and selling a put option involve expecting the price to rise, but the similarity ends there. If someone is confident the price will rise, they would buy the shares directly instead of buying call options. Similarly, if someone expects the price to fall, they would buy put options.

Options writers, typically shareholders, sell options to protect themselves from price fluctuations and potentially gain from them. By selling options, they commit to fulfilling their obligation if the buyer exercises the option.

The option writers (sellers) have an opposite view to the buyers. Here's a summary:

• Option writers (sellers) have an opposing view to the buyers:

  • Sell calls (give the right to buy) when they expect the price to fall.

  • Sell puts (give the right to sell) when they expect the price to rise.

• Buying calls and selling puts both bets on a price increase, but:

  • Buying calls is a direct bet on a price increase.

  • Selling puts is a way for shareholders to safeguard against price volatility while potentially gaining from it.

• Option writers are obligated to perform their part of the contract if the buyer exercises the option.

The key difference between buyers and sellers of options is that option writers, often shareholders, seek to manage risk and generate income, whereas buyers seek to profit from price movements. 

Here is a summary of what we saw above. 

1. Stock exchanges introduce options contracts.

2. Call options give the right to buy, while Put options give the right to sell.

3. Buyers of options are called holders, while sellers (writers) are obligated to perform.

4. Holders have limited losses and unlimited gains (for call options) or limited losses and profits (for put options).

5. Writers have unlimited losses (for call options) or limited losses and profits (for put options).

6. Option writing is risky due to the obligation.

7. Buying call options is bullish (expects price increase), while buying put options is bearish (expects price decrease).

8. Option writing is used to manage risk, safeguard profits, or generate income.