By Hemanth Gorur
While investors are familiar with stock market instruments like shares and mutual funds, there is another class of investment instruments called Options, which are advanced investment instruments.
While options exist for assets in the commodities market as well, we will be restricting ourselves to the stock markets here. Let us see what options are.
A unique agreement
Suppose your friend has 100 grams of gold worth Rs 5 lakh kept in a bank locker. There are two locks for this locker and you need both keys to open this locker for ownership of its contents. You are considering buying the gold but are not sure if gold prices will rise in future or not. Yet, you do not want to miss the opportunity to buy it at a low price in case the price does go up later. So you get into a unique agreement with your friend, wherein you get the first locker key upon paying an upfront fee of, say, Rs 50,000. This means you have the sole right to open this locker or get ownership of its contents if you choose.
Since you need some time to decide on whether to buy it or not, you also agree with your friend to come back sometime after three months and buy the gold at a specific agreed upon price, say Rs 6 lakh, at which point you will get the second locker key, and thus ownership of the gold. It is also agreed that if you do not come back after three months to buy the gold, you will forfeit the upfront fee, at which point you will return the first locker key to your friend.
The concept of options
The concept of options is similar. When you buy an option in the stock market, you get the right to buy (or sell) the underlying asset at a later point in time, called “expiry”. This right is your first locker key as in the bank locker example. The expiry period is similar to the three-month period in the bank locker example.
The underlying asset for an options contract is a company’s shares, similar to the 100 grams of gold earlier. The upfront fee here is called the “premium”. The final agreed upon price at which you agree to buy (or sell) the shares later is called the “strike price”. Also, an options contract usually specifies a fixed minimum number of shares, called the “lot size”.
Types of options & implications for investors
When you buy the right to buy shares, you are buying a call option. This happens when you expect the share price to rise later, so you want to lock in a good (low) buying price. For example, say the current share price is Rs 100, and you buy a call option with a one-month expiry and strike price of Rs 115, for a premium of Rs 10. If you do exercise your right to buy at expiry, your cost will be Rs 125 (strike price plus premium). Clearly, you will exercise your right to buy the share at expiry only if the share price at expiry is more than your cost of Rs 125. In which case, you will buy the share at the strike price of Rs 115 and immediately sell it to pocket the difference. If the share price is less than Rs 125, you simply walk away without buying and lose only the premium of Rs 10.
The other type of option is the put option, where you buy the right to sell shares. This works in exactly the opposite way. You buy a put option when you expect the share price to fall later, so you want to lock in a good (high) selling price.
Assuming the same numbers as above, with a strike price of `95, you will exercise your right to sell the share when the share price at expiry is less than Rs 85 (strike price minus premium), in which case you will immediately buy the share from open market and sell at the strike price to make a profit. Else, you walk away and forfeit only the premium paid.
Call & Put Options: Terms of Reference
- When you buy the right to buy shares, you are buying a call option. This happens when you expect the share price to rise later, so you want to lock in a good (low) buying price
- You buy a put option when you expect the share price to fall later, so you want to lock in a good (high) selling price
- The final agreed upon price at which you agree to buy (or sell) the shares later is called the strike price.
The writer is founder, Hermoneytalks.com