Make sure to check out my other article, “4 ways to invest Gold in India”.
In this article, I am going to discuss what derivatives are and how Future and Options work. So let’s dive right in.
What do you think about when you hear the word, “derivative”? Sounds like something is derived from something else. In the finance world, it has a very similar meaning. Derivatives are the financial instrument that has a value derived from another underlying security.
The underlying security could be a currency, equity, index, commodity, bonds, rate of interest, or even the livestock. As the security price varies, the respective derivative price also varies. There are 4 different derivatives in the market, Forwards, Futures, Options, and Swaps.
We are going to discuss only Options in this article.
Options are a bit complicated derivative. To understand the options, lets first understand how insurance works. Then we can correlate easily.
Let’s say if you have a car and you bought car insurance from some insurance company. So you will pay some premium amount monthly or annually. If something happens to the car, the insurance company pays you a big lump sum as a claim.
In options, as a buyer, you purchase an options contract and pay the premium. Now the options type could be either “call” and “put”. But more on that later. As a buyer of the contract, you insure your deal with premium payment and limit your maximum loss. The maximum loss for a buyer of the contract is equal to the premium amount in either type of option.
Let’s take an example of a call option for this one. So the contract buyer is bullish (who thinks the market will go up) and the contract seller is bearish. The stock price of the particular stock today is 100 rs. In 3 months of the contract, the buyer thinks the price will go beyond 150, and the seller thinks the price will stay below 150. So both parties bet on the situation as a contract and 150 is called the strike price.
The minimum number of stocks/security to be traded in the contract is called a lot size. Number of securities in the contract are always in multiple of lot size.
Note* : Contract buyer and Contract seller terminology has nothing to do with who performs sell or buy of the security.
In the call option, the contract buyer is bullish and he wants to purchase the security. He thinks the security price will go up and beyond the strike price. On the other hand, the seller thinks that the price will stay below the strike price. As the option buyer, he will pay the premium amount to the contract seller upfront.
Now there are 2 possibilities.
1] Price could go beyond the strike price.
The initial stock price was 100. Now the price has gone to 200. In this case, the buyer has won. He could now exercise his right to buy the stocks. The seller has the obligation to sell the stocks at strike price only, which is 150. The buyer can buy the stock lot at 150 rs per share and resell in the open market at 200 rs per share and register the profit of 50 per share.
Total profit, in this case, will be (current price – strike price) * lot size – premium.
2] Price could stay below the strike price.
Let’s say the current price(at the end of the contract) is 120rs per share, which is below the strike price 150rs. Now the buyer does not have any obligation to purchase the stocks from the seller at the strike price(150 rs). He would rather buy the stocks from the open market at 120rs per share. So the buyer just pays the premium to the contract seller. Let’s say the premium could be 1500rs.
In the put option, the contract buyer is bearish and he wants to sell the security. He thinks the price will stay below the strike price. On the other hand, the contract seller thinks the price will go beyond the strike price. Again the contract buyer will pay the premium to buy the right to sell.
Again, two scenarios are possible.
1] On/near expiry, the price stays below the strike price. The initial stock price was 100 and now it is 120rs. The strike price is 150rs. The contract buyer will now exercise his right to sell. The seller will have the obligation to purchase the stocks from the contract buyer at the strike price(in this case, 150). Contract buyers can then short the stocks in the open market to register the profit.
Profit to option buyer in this case: (strike price – current price) * lot size – premium
2] On/near expiry, the prices shoot above the strike price. The price goes to 200. The option buyer now doesn’t profit from selling his security at the strike price. He would rather sell the lot in the open market. The option buyer now has no obligation to sell the stocks to the option seller. Hence, he can just pay the premium and close the contract. The option seller in this case will profit the premium(1500rs).
An Option is regulated derivative and traded on the exchange. Considering the risk involved, only high worth individual investors or institutional investors prefer to trade in the Options market.
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