This article was originally published in Postnoon on June 22nd, 2012
Srikanth owns stocks of ABC Ltd. After he learnt about the concept of futures and hedging from professor Nicky, he used the futures contracts on ABC Ltd. to hedge the risk of a downward slide in the share prices. Unfortunately for him, just a few days after he entered the contract, the company announced its quarterly earnings and the stock prices have gone up steadily ever since.
The value of his stocks are now higher. That’s good news. But he does not intend to sell the stock. On the other hand, his losses are very real! He started getting margin calls from his broker. So he closed out his position in the futures market, before his losses become larger.
However, this led him to think of how it would be great if he could have the good part of futures without the obligation to honor the contract!
“Naah…I guess that would be too good to be true…”, thought Srikanth. Nevertheless, he walked into prof. Nicky’s room to share his experience with futures with the professor.
Prof Nicky: Well, as a matter of fact, such instruments do exist. They are called Options. By buying an option, you can lock in a price but can choose not to exercise your option if the market offers a more advantageous price.
Srikanth: Buying an option?
Prof. Nicky: Perceptive as always Srikanth. Yes, you buy an option. Since you have a right but no obligation to trade your stock at a pre-determined price, you pay a premium. Else it would be like being able to have your cake and eat it too!
Srikanth: Hmmm… though that would be great, I suppose no one would sell options for free, so this situation seems fair enough. So how about if I want to be able to sell a stock? Can I buy an option to sell a stock?
Prof. Nicky: Yes Srikanth, weirdly as it sounds, you can buy an option to sell a stock… It’s pretty interesting actually, there are fundamentally two types of options, a call option which allows you to buy stock and a put option that allows you to sell stocks. Buying an option allows you to, at a cost, transfer risk to the seller of the option. A simple call or a simple put option are also referred to as plain vanilla options.
Srikanth: Professor, in the futures market, we can buy and sell our contracts any time. Can we do the same in the Options market?
Prof. Nicky: Indeed you can buy and sell them anytime at the price (premium) in the market. However, you can exercise your options anytime only if they are American in nature. Now… before you ask… no you don’t need to be in America to be able to trade in American style Options. It’s just nomenclature.
Options which can be exercised anytime up to expiration are called American Options, where as those which can be exercised only on the day of expiration are known as European style options. Both kinds of options are traded all over the world. In India, the index options are European in nature, while the stock options are American!
Srikanth: They don’t seem too plain to me… But why would anyone sell options? The seller seems to take on a lot of risk!
Prof Nicky: Great question! Simple answer — for the premium. The person writing the option believes that the probability of the option being exercised is very low. So he gets to collect and keep the premium.
Srikanth: Wow!… this is information overload for now..but how about we continue this discussion next week and you tell me how someone like me can use options?
Prof Nicky: Sure!