Monday, July 2, 2012

Understanding Options

This article was originally published in Postnoon on June 29th, 2012

Srikanth: Hi Professor! Hope you have some time because I have a ton of questions!

Srikanth: How would buying an option differ from buying a stock?

Prof Nikki: when you buy a call option, you own the right to buy the stock. But you do not own the stock and therefore have no right over dividends. Also, the extent to which the price movement of the option imitates the price movement of the stock depends on the strike price and the stock price.

Also, you own a stock till you sell it, but an option expires. It is an instrument with limited life.

Srikanth: What do you mean by the strike price?

Prof Nikki: Strike price is the price at which you will buy or sell the underlying asset. The current market price, on the other hand, is known as the spot price.

Srikanth: So when would you suggest I buy options?

Prof Nikki: There are several scenarios when buying options would be a good idea. The first case I can think of is when the prices of a stock you own are falling rapidly.

This is a situation that no one likes. And to protect yourself from potentially large losses, you can buy a put option to sell the stock at a certain acceptable price.

Srikanth: A quick question here Prof, can I buy options in such a way that I can make a profit by exercising it right away?

Prof Nikki: Hypothetically, by buying an in the money call, that is, a call with strike price less than market price, you should be able to make instant profit. But in reality, the options are priced to take into account the time value of money. Which means, factors like interest rates, time to expiration, volatility of the stock etc. are taken into account by the market, making it very difficult to make money by exercising the option right away.

Srikanth: Hmmm… so what are the other situation where buying an option would be good for me?

Prof Nikki: Like I said earlier, there are several situations. Before I tell you more, I really need you to understand that options are instruments that offer immense leverage because you are paying only a fraction of the money in the form of the premium. You actually pay for the stock or the commodity when you exercise the option. While this seems like a good strategy, you should always be careful and manage risk.

Srikanth: I understand Professor… Do you think it would be a good idea to buy call options on a stock that I am optimistic about?

Prof Nikki: You are learning fast indeed! It is a good idea. But please remember that if you plan to actually exercise the option, you will need to have enough capital to buy it at the strike price.

As a matter of fact Srikanth, there are several strategies that one can use with different combinations of options. But the more complex strategies need to be managed regularly. It is advisable to take help of a portfolio manager if you are serious about investing in futures and options.
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