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 - Futures and Options. In the following note two different types of Options - Put option and Call Option 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 this example let us say that the company is Coca Cola and the current price of its stock is Rs.50. However instead of just buying the shares from the market what you do is the following: 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 to decide 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 at Rs.52 in which case you will gain by simply buying from Kiran at Rs.52 and selling it in the market at the price which is above Rs.52. Kiran will be at a loss in this situation. 2. If the stock price remains below Rs.52 then you simply won’t buy the shares from him. After all you are asking Kiran is the 'option' to buy those shares from him - you are not making any commitment. In order to make the above deal 'fair' from the viewpoint of Kiran you agree to pay Kiran Rs.2 per share, i.e. Rs.200 in total. This is the (risk) premium or the money you are paying Kiran for the risk he is willing to take - risk of being at a loss if the price rises above Rs.52. Kiran will keep this money irrespective of whether you exercise your option of going ahead with the deal or not. The price of Rs.52, at which you would like to buy (or rather would like to have the option to buy) the shares is called the strike price of this deal. Deals of this type have a name- they are called a Call Option. Kiran is 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 1

Stock Options –A Conceptual Note

from him. You on the other hand are the buyer of the call option and have no obligation- you simply have the option to buy the shares.

Simple Put Option Example - How put option works?
Let us consider a situation where now Kiran wants the option to sell you his 100 shares of Coca Cola at Rs.48. He agrees to pay you Rs.2 per share in order to be able to have the 'option' to sell you his 100 shares at the end of the month. Of course what he has in mind is that he will sell them to you if the price falls below Rs.48, in which case you will be at a loss by buying the shares from him at a price above the market price and he will be relatively better off rather than selling the shares in the market. The Rs.2 he is willing to pay you is all yours to keep irrespective of whether Kiran exercises the option or not. It is the risk premium. In this case John is buying a Put Option from you. You are writing or selling a Put Option to John. Rs.48 is the strike price of the Put Option. In this case, you the seller or writer of the Put Option has the obligation to buy the shares at the strike price. Kiran, the buyer of the Put Option has the option to sell the shares to you. He has no obligation.

Difference between above option examples and 'real life options'
The above examples illustrate the basic ideas underlying, writing a call, buying a Call, writing a Put and selling a Put. In real life you sell (or write) and buy call & put options directly on the stock exchange instead of 'informally dealing' with your friend. Here are some key points to remember about real life options trading. 1. An option trading is directly or automatically carried through at the stock exchange, you do not deal with any person 'personally'. The stock exchange acts as a 'guaranteer' to make sure the deal goes through. 2. Each Options contract for a particular stock has a specified LOT SIZE, decided by the stock exchange. 3. The writers or sellers of Call and the Put option are the ones who are taking the risk and hence have to pay 'margin' amount to the stock exchange as a form of guarantee. This is just like the margin money you pay while buying or selling a futures contract and as explained in the note on futures trading. The buyers of Call and Put options on the other hand are not taking any risk. They do not pay any margin. They simply pay the Options premium.

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