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Introduction to options
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Options are contracts which give the holder the right to buy/sell the underlying asset at a predetermined amount (strike price/exercise price) before/at the expiry (depending upon whether the option is American/European). It is an important point to note that the holder/buyer of the option may/may not exercise his right. It is an option and, not an obligation for the purchaser of the option to buy/sell the underlying. However, to buy such a right, the buyer of the option has to incur some cost in terms of 'option premium'. Irrespective of whether the underlying asset is actually purchased/sold or not, the option premium always needs to be paid to the seller and, remains with the seller of this right/option.

The option seller/writer has an obligation to sell/buy the underlying in case the option buyer chooses to exercise his option to buy/sell. And, therefore, the maximum profit that an option seller can make is limited to the premium received (when the buyer lets his right lapse).

Options can be classified as follows:

  • Call options and Put options: A call option gives the holder a right to buy (not an obligation) to buy the underlying at the strike price by paying the premium. If he chooses to exercise this right, the seller will be obligated to sell the underlying at the pre-defined price.

Similarly, a put option gives the holder a right to sell the underlying at the strike price by paying a premium. If he chooses to exercise this right, the option seller will be obligated to buy the underlying at the strike price.

For instance, an investor A, enters into a contract with B where A has the right to buy 500 shares of XYZ Ltd. @ Rs 60 each on or before a specified date. This is call option.

In the same case, if A has the right to sell instead of buying, it is called put option.

Further, A may or may not exercise his right. If he doesn’t exercise his right, it will lapse after the specified date. In order to acquire this right, A has to pay a price to B; called option premium.

  • American options and European options: In the American options, the option holder can exercise his right to buy/sell the underlying at any time before the option expires. This includes the option of exercising the right before the expiry of the contract.

European options, on the other hand, can be exercised only at the expiry and, not before that.

This likelihood of early exercise makes the American options more profitable choice that the European ones for the option buyer.

For instance, share PQR is trading in the market at Rs 85 and one month put option is available at strike price/exercise price of Rs 80. Now suppose, in the mid-month, the price reduces to Rs 74 and on the expiry, the rate is Rs 82. In case of American option, the investor can exercise his right and can gain Rs 6 per share. But in case of European option, he will have to wait till the end, and will incur a loss of Re 2 per share.

 

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