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Finance for Common Person

Exploring Stock Options

Finance for common man is a series of articles on various finance topics, which will be useful to people who does not have finance background .

This article is on Options (so called financial derivatives or Options and Future). We will explore about Options, a derivative instrument, in this article. I have tried my best to make this document simple so that anyone, not necessarily a Wiz in finance, can understand. I have not used any graphs or much of technical terms. If you have any feedback/suggestions/criticism, please let me know @ rameshbaboov@gmail.com

Volume- I, Series- 1

MINNANJAL Vol -1- Finance for Common Man Series -1

Contents
1 2 Why to learn Options ....................................................................................................................... 3 Basics of Option ............................................................................................................................... 3 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3 4 What does Option mean? ......................................................................................................... 3 ESOP- Employee Stock option ................................................................................................... 3 Stock Option............................................................................................................................. 4 Option and Contract ................................................................................................................. 4 Difference between trading in Shares and Option..................................................................... 4 Selling the option ..................................................................................................................... 5 American/European option ...................................................................................................... 5 Risks in Option.......................................................................................................................... 5 Few technical terms ................................................................................................................. 6

In the forthcoming series ................................................................................................................. 6 Reference ........................................................................................................................................ 7

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MINNANJAL Vol -1- Finance for Common Man Series -1

1 Why to learn Options
Option is a very useful instrument which can be used in multiple ways.. Options can be used as insurance for your existing assets. This asset can be either financial asset or even physical asset. By trading in options, like Stocks, you can earn money. If you hold good volume of shares, options can be used to sell your shares at a better price. Lastly options are used to bet on share prices and people who are involved in such activities are called speculators If you are not the one who wants to practice it, still options is an interesting subject but is equally complex.

2 Basics of Option
2.1 What does Option mean?
The dictionary meaning of word Option means power or right to choose and comes from the Latin word Optio, which means free to choose. In the world of finance, the word Option or Options also mean the same thing. The buyer of the option has the rights to either exercise his options or to leave it as it is. He has no obligation.

2.2 ESOP- Employee Stock option
ESOP or employee stock option is one type of option which is famous among many of us. Discussion on ESOP will help one to better understand about options. However, Stock options are more complex than ESOP. An employer gives the right to buy shares of employer s organization at a fixed price (called exercise price) to the employee. Usually ESOP cannot be exercised (i.e converted to shares) immediately. The employee needs to wait for a definite time period before he/she can use the option and buy the shares. If the stock price increases or appreciates in the mean time, then it benefits employee to buy the stock using ESOP at the exercise price. However, if the price does not increase or if the price decreases, employee will not be motivated to buy using ESOP at a high price. So employee has the option to either buy or not to buy at his/her discretion. So this is a type of option.

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MINNANJAL Vol -1- Finance for Common Man Series -1

2.3 Stock Option
We will restrict our discussion to stock option, but the same applies to other options like Options on commodities etc. In nutshell, a stock option gives the buyer right to buy or sell stocks, but not the obligation. This means that the buyer is free to choose whether he want to buy or sell the stock and naturally this choice would be always made if it is favorable to buyer

2.4 Option and Contract
Buying an option is like entering into a contract to buy/sell shares. For entering into this contract you need to pay an initial fee, called premium. But this contract can be either honored or broken by you. Premium is like a non-refundable fee and this is only a small percentage of the total price of the shares to be bought or sold. Premium is the cost of entering into option irrespective of whether you honor the contract or not. Options, like any other contract, have an expiration date after which the contract will cease to exist.

2.5 Difference between trading in Shares and Option
Now you would have understood that option is all about entering into a contract for selling or buying a share. There are few differences in buying/selling shares directly or using options. Share are usually bought or sold on the same day when entered into the transaction. But Option is not to sell or buy on the same day when you enter into a contract, but for a future date. This is very trivial. The amount of money that you need to invest when you are trading in shares is very high. Whereas in case of options, the amount is very less. All you need is a small amount of money called premium to enter into contract. Say for example, cost of share is say 100 currencies (USD/Euro/Rs) and if you have 2000 in hand, the maximum shares you can buy is only 20. Whereas in case of options, the premium is only a percentage of 100 and hence you can buy say 200 shares assuming premium is 10% of total share value. An option is only to buy/sell a specific share and usually of a large quantity and not just one share. Because of this, the investment required to enter into option contract is high, though not as high as directly buying the share of equal size.

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MINNANJAL Vol -1- Finance for Common Man Series -1

2.6 Selling the option
If you are ready to enter into a contract to buy/sell a stock, someone must be ready to accept your offer. i.e. sell this offer to you. Without this, no trade happens. So the person who offers this contract is the seller of the contract. So you are buying the option and this person is selling the option to you. However, he has to always honor the contract and cannot break the contract like you. There will be a commotion, if both the parties can break the contract and such a contract is not a contract at all. Say for example, if current price of a share is 100 Rs/Euro/Dollar and you want to buy a contract to buy 1000 shares amounting to a total of 100,000 Rs/Euro/Dollar. The contract expires in one month from now. At the time of end of contract if the price is 50, then you will not find it profitable to buy from this person through the contract. You can buy from the market. So you can break the contract. However, if the price increases then you will find it profitable to buy from this person. So you have a chance/option. But the other person cannot refuse to sell to you, though it may not be profitable to him. But he/she gets the premium which you pay as a guarantee for the contract If you think why one person should enter into such a unilateral contract, then there are many reasons which we will see later. So in nutshell, buyer of the contract has right but no obligation, but seller of the contract has only obligation.

2.7 American/European option
An option is said to be American option, then one can exercise the option (i.e. Buy or sell the underlying stock) at time during the life time of the option. However, if the option is European option, then the option can be exercised only on the day of expiry.

2.8 Risks in Option
Like any financial instrument or like Stocks options are also risky. However the amount of risk depends on whether you are buying the option or selling the option or if you are doing a mix of these or any one of these with other financial instruments In a simple case of buying the option, the maximum loss that you can have is only the premium. This is because, you will not exercise the option if it is not favorable to you and you will forgo the money. Hence risk is very limited. But if you are selling the option, then the maximum loss is theoretically unlimited. Because in previous example, if the price of the stock rises to 200 from 100, you still cannot refuse to sell the stock and you are loosing 100 per stock (200 rs current price 100 rs sale price), which otherwise you could have sold outside the contract in open market. So if you are seller of option, your loss in unlimited

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MINNANJAL Vol -1- Finance for Common Man Series -1

2.9 Few technical terms
y y y y y y y y y y y Derivative - A financial instrument whose price is based on change in value of underlying stock. For example Value and premium of option are dependent on the price of the stock underlying Underlying Stock This means that the stock on which the option is based. I.e. the stock for which the option exists to sell or buy Lot one lot is a clubbing of multiple shares. For example one lot can contain 50 shares Long - Buying something, i.e. Option that is being bought. Long means buying the option and not the underlying stock. Note that the stock can be either bought or sold in the option. Short Selling something. I.e. option is being sold. Short means selling the option and not the underlying stock. Note that the stock can be either bought or sold in the Option Call Option Option to buy a stock in future by buyer of contract Sell Option Option to sell a stock in future by buyer of contract Long Call An option that is being bought by a person (Buyer) by giving premium to the seller of the option and the option is to buy a certain stock in future by the buyer Long Put An option that is being bought by a person(Buyer) by giving premium to the seller of the option and option is to sell a certain stock in future by the buyer Short Call An option that is being sold by a person (Seller) by receiving premium from the buyer of the option and the option is to buy a certain stock in future by the buyer Short put An option that is being sold by a person (Seller) by receiving premium from the buyer of the option and the option is to sell a certain stock in future by the buyer

3 In the forthcoming series
y y y y y y y y y y Options in practice Speculation/Hedging What is long/short/call/put and trick of remembering? Underlying securities in options Choosing an option Call or Put? Option - who makes money and who loose? Cost-Price of option Options in Indian Stock market Option Strategies and risks involved Is Options a Gambling? Why should someone get involved in short position?

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MINNANJAL Vol -1- Finance for Common Man Series -1

4 Reference
Marriam websters dictionary - http://www.merriam-webster.com/dictionary/option

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