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Stock Options

Stock Options

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This note will guide about ;How the Options market Works?
This note will guide about ;How the Options market Works?

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Published by: Professor Sameer Kulkarni on Apr 28, 2010
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Stock Options –A Conceptual Note
 
A Note By: Sameer Kulkarni, Associate Professor, HOD Chanakya, Mumbai ______________________________________________________________________________ 
 There are two derivative instruments which every investor must know of - Futuresand  Options. In the following note two different types of Options - Put option and CallOption are explained, with an example.
1.
Buying a Call Option 
.
2.
Selling a Call Option 
(also sometimes called as
writing a Call Option 
).
3.
Buying a Put Option 
.
4.
Selling a Put Option 
(also sometimes called as
writing a Put Option 
).Whether it is stock options or commodity options, the underlying concept is the same.
Simple Call Option example - How call option works?
Suppose you are interested in buying 100 shares of a company. For the sake of thisexample let us say that the company is Coca Cola and the
current price
of its stock isRs.50. However instead of just buying the shares from the market what you do is thefollowing: You contact your friend Kiran and tell him "Hey Kiran, I am thinking of buying 100 shares of Coca Cola from you at the price of Rs.52. However I want todecide whether to actually buy it or not at the end of this month. Would that be OK?"(Of course what you have in mind is the following).
1.
If the stock price rises above Rs.52, then you will buy the shares from Kiran atRs.52 in which case you will gain by simply buying from Kiran at Rs.52 andselling it in the market at the price which is above Rs.52. Kiran will be at a lossin this situation.
2.
If the stock price remains below Rs.52 then you simply won’t buy the sharesfrom him. After all you are asking Kiran is the 'option' to buy those shares fromhim - you are not making any commitment.In order to make the above deal 'fair' from the viewpoint of Kiran you agree to payKiran Rs.2 per share, i.e. Rs.200 in total. This is the
(risk) premium
or the money youare paying Kiran for the risk he is willing to take - risk of being at a loss if the pricerises above Rs.52. Kiran will keep this money irrespective of whether you exercise youroption of going ahead with the deal or not. The price of Rs.52, at which you would liketo buy (or rather would like to have the option to buy) the shares is called the
strikeprice
of this deal. Deals of this type have a name- they are called a
Call Option
. Kiranis
selling (or writing) the call option
to you for a price of Rs.2 per share. You are
 buying the call option
. Kiran, the
seller of the call option 
has the
obligation to sell
his shares even if the price rises above Rs.52 in which case you would definitely buy it
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