Monday, May 23, 2005

All you want to know about financial options

May 23, 2005, www.rediff.com. Co-author-Vivek Kaul

Options are the most popular class of derivatives around the world. But, surprisingly, options are not very popular in India. At present option contracts are available on 108 individual stocks and the Nifty and CNXIT Indices.
The index options and stock options together account for just 12 per cent of the derivatives market segment on National Stock Exchange. In this article, we will try and explain the trading mechanism of options contract in a simple manner.
Introduction
Options are contracts which give the holder or the buyer of the contract the right to buy (Call option) or sell (Put option) the underlying at a certain price (strike or exercise price) at a certain date (expiry date) or within a certain period in future. (For details, see All you wanted to know about derivatives).
However, the holder is not obligated to buy or sell the underlying. Thus, an option gives the holder a cushion from any unfavourable price movements in the underlying and also allows the holder of the contract to take advantage of any favorable price movements.
This flexibility of course comes at a premium. The buyer of the option is required to pay a premium to the seller of the option in order to acquire this option.
There are two major types of options. These are American Options and European Options. American options allow the holder the flexibility to exercise the option at any time before the expiry.
On the other hand, European Options allow the holder to exercise the option only upon expiry. Needless to say, American Options give more flexibility to the holder.
The underlying in case of financial options can be either an index or the stock of an individual company. An option contract, whose underlying is the stock of an individual company, is known as stock option.
Similarly, if the underlying is a stock market index, the contract is known as an Index options contract. On the National Stock Exchange, the index options are European in nature i.e. they can be exercised only upon expiry, where as the stock options are American in style, i.e. they can be exercised any time before the expiry.
The seller of the option contract is known as the writer of the contract. He receives the premium from the buyer, and that is his maximum profit in all circumstances as we will see later.
But the losses can be unlimited for a person who is writing an option. Lets see understand all this with the help of an example.
Call Options
Let us look at an investor (say, Mr Bull) who believes that the share price of Infosys is going to rise. So on May 13, 2005, he decides to buy 100 shares of Infosys which are selling for say Rs 2,040. His investment will be Rs 204,000. The person sells the shares on May 26, 2005 when the share price is Rs 2,100.
The profit for Mr Bull, will be 100*(2,100-2040) = Rs 6,000 on an investment of Rs2,04,000. This implies a return of 2.9 per cent.
Now instead, lets say Mr Bull buys Infosys Call options at a premium of Rs 40 per option (100 is the minimum contract size for stock options on NSE, although the contract size varies from stock to stock) from an investor (say, Mr Bear) who expects the price of the Infosys stock to fall. The premium paid by Mr Bull to Mr Bear is Rs 4,000 (Rs 40*100).
The Call options give Mr Bull the right to buy 100 shares of Infosys at Rs 2,040 (strike price) each from Mr Bear, upon expiration on May 26, 2005. The value of the contract stands at Rs 204,000 (Rs 2040*100).
Now, if the price of an Infosys share is Rs 2,100 each (spot price) on the expiry date, the holder of the option contract, i.e. Mr Bull will exercise his option. Mr Bear will have to hand over 100 shares of Infosys to Mr Bull at the strike price, i.e. Rs 2,040.
Mr Bull can then sell these shares in the market for Rs 2,100 and make a profit of Rs 6,000 (as he makes a profit of Rs 60 per share). But since all the financial derivative contracts on NSE are settled in cash, no delivery of the underlying is made.
Hence, the contract will be settled by the seller of the option paying an amount of Rs 6,000 to the buyer of the contract. The Rs 6,000 is calculated as the difference between the spot and the strike price, multiplied by the number of options.
The net profit of the buyer will be Rs6,000 less the premium paid (Rs 4,000), i.e. Rs 2,000. Mr Bull makes a profit of Rs2,000 on an investment of Rs 4,000, i.e. return of 50 per cent.
Mr Bull, the buyer of the option will exercise his option in two cases: a) when he makes a profit (As has been clearly shown in the above example) b) when he can minimize his loss.
Lets say on May 26, 2005 (the expiry date), the spot price of Infosys is Rs 2,070 (instead of Rs 2,100 in the earlier example). Mr Bull exercises his option. Mr Bear pays Mr Bull Rs 3,000 [(Rs.2070-Rs.2040)*100].
But Mr Bull has already paid Mr Bear a premium of Rs 4,000.So he makes a loss of Rs 1,000. But if he had not exercised his option he would have made a loss of Rs 4,000. So even though he ended up making an overall loss it made more sense for him to exercise the option.
Given this, it always makes sense for the buyer of the Call option to exercise the option as long as the spot price (on the expiry date) is greater than the strike price. Since the stock option traded on NSE are American options, Mr Bull can exercise the option on any day before expiry.
On the other hand, if the spot price of Infosys on the expiry date, is less than the strike price, lets say Rs 2,000, the investor will not exercise the option and let it expire.
In this case, his maximum loss is Rs 4,000; the amount of premium that he had paid. Thus, the loss is limited to the premium paid, and gain can be unlimited, depending on how much greater the spot price of the share on the date of the expiry of the option is vis a vis the strike price.
The position will be reversed for the seller of the option. The seller of the option is obligated to buy or sell the underlying if the buyer decides to exercise the option.
So the loss for the seller of the option is unlimited (The greater the spot price is vis a vis the strike price, the greater the loss for the seller of the Call option). Also, the seller will have to pay an initial margin to the exchange. This is because the seller of the contract can have unlimited losses.
So to prevent any default from the seller, the exchange takes this margin, which is refunded upon the expiry of the contract. Just like in the futures contracts, the seller's account is marked to market (MTM) on a daily basis.
The seller is liable to pay to the exchange on a daily basis any loss due to the change in the price of the contract and receives any gains. (For details, see All about financial futures).
In the above example, the seller will sell the option for a premium of Rs 4,000. Plus he will have to pay an initial margin of say 10 per cent of the contract value to the exchange, which will be Rs 20,400 (10% of Rs 204,000, the value of the contract). This is of course refunded when the contract expires.
On final settlement, the seller will have to pay the buyer the difference between the exercise price (Rs 2,040) and the market price of the share(Rs 2,100), multiplied by the number of options (Rs 100), i.e. Rs 6,000 (Rs 60*100).
But, his maximum profit can only be the amount of premium received, i.e. Rs 4,000. In spite of this, the seller sells the option because he thinks that the price of Infosys will fall and the buyer will not exercise the option, thus he can easily pocket the Rs 4,000 premium received.
Put Options
Put option is bought by an investor who believes that the share price of a company is going to fall. The counterparty is a person who believes that the share price of the same company is going to rise, hence he writes a Put option.
The Put option works exactly opposite to the Call option. The buyer of the Put option will exercise the option if the share price drops below the exercise price. His profit will be the difference between the exercise price and the spot price at maturity, less the premium paid for the option.
For the writer of the Put, the maximum profit is once again only the premium received, but the loss is equal to the difference between the exercise price and the spot price, multiplied by the number of options. Call options in India are more popular than Put options.
Conclusion
There are various combinations of Options, which are used to make money in different circumstances. But the fact remains that derivatives in general and options in particular are fairly risky investments (As our examples have shown).
Investors should invest in them if and only if they have a fairly good understanding of the stock market, the economy and the instrument itself. Happy investing.
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