Working of Options

In one of our previous blogs, we gave a brief introduction as to what options are.

To Read the first Blog in this Series Click here 

Let us now understand how options work.

Suppose, the current market price of a share X is Rs 50. An investor is bullish on the stock and expects the price to increase to Rs 60. If the options are not available, he can buy 500 shares by paying Rs 25,000 (500*50) on the current date. If the price increases as expected, the option holder will benefit by selling the shares at that time. However, losses may also be suffered amounting to the difference between Rs 50 and the price to which the stock falls to.

As an alternative, an option can also be bought. For instance, let us suppose the investor buys a call option to buy 500 shares at a cost of Rs 3 per share where the exercise price is Rs 52. A total premium of Rs 1,500 (500*3) will be paid to the option writer. Now, if, on the expiry, the price happens to be more than Rs 52 per share (say, Rs 57), the investor can exercise his option and will make a profit of Rs 1,000 i.e., [(57-52)*500 – Rs 1,500]. However, if the actual price turns out to be less than Rs 52, then he may allow the option to lapse and his loss will be limited to the premium paid i.e., Rs 1,500

Working of Options

Now, let us understand how does a put option work. Suppose, an option has strike price of Rs 1,000 per share and the option premium of Rs 100 per share. As discussed before, the option holder has a right to sell the underlying asset at the strike price/exercise price.

The put option holder would exercise the option so long as the market price is less than Rs 900 = Rs 1,000 – Rs 100 and, would make profit. However, if the market price is Rs 900 or more, he would let the option to lapse, or would incur loss.

For a put option seller, there would be a loss if the option is exercised by the holder. And, the profit will be limited to the option premium in case the option is not exercised.

Working of Options


Rustagi, Dr. R.P., Investment Management: Theory and Practice (2008)

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