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What is an option?

An option is a contract giving the buyer the right, but not the obligation, to b uy or sell an underlying asset (a stock or index) at a specific price on or befo re a certain date. An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock (equity) . In the case of an index option, its value is based on the underlying index (eq uity). An option is a security, just like a stock or bond, and constitutes a binding co ntract with strictly defined terms and properties. Call Options and Put Options Some people remain puzzled by options. The truth is that most people have been u sing options for some time, because option-ality is built into everything from m ortgages to auto insurance. In the listed options world, however, their existenc e is much more clear. To begin, there are only two kinds of options: Call Options and Put Options. A Call option is an option to buy a stock at a specific price on or before a cer tain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security depo sit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would ha ve no other liability. Call options usually increase in value as the value of th e underlying instrument increases. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price, called the s trike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. Put options are options to sell a stock at a specific price on or before a certa in date. In this way, Put options are like insurance policies. If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happen s, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decrease s. If all goes well and the insurance is not needed, the insurance company keeps yo ur premium in return for taking on the risk. With a Put option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" y our asset, you can exercise your option and sell it at its "insured" price level . If the price of your stock goes up, and there is no "damage," then you do not ne ed to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manag

e risk. Options Premiums An option Premium is the price of the option. It is the price you pay to purchas e the option. For example, an XYZ May 30 Call (thus it is an option to buy Compa ny XYZ stock) may have an option premium of Rs.2. This means that this option costs Rs. 200.00. Why? Because most listed options a re for 100 shares of stock, and all equity option prices are quoted on a per sha re basis, so they need to be multiplied times 100. More in-depth pricing concept s will be covered in detail in other section. Strike Price The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract. For example, with the XYZ May 30 Call, the strike price of 30 means the stock ca n be bought for Rs. 30 per share. Were this the XYZ May 30 Put, it would allow t he holder the right to sell the stock at Rs. 30 per share. Expiration Date The Expiration Date is the day on which the option is no longer valid and ceases to exist. The expiration date for all listed stock options in the U.S. is the t hird Friday of the month (except when it falls on a holiday, in which case it is on Thursday). For example, the XYZ May 30 Call option will expire on the third Friday of May. The strike price also helps to identify whether an option is in-the-money, at-th e-money, or out-of-the-money when compared to the price of the underlying securi ty. You will learn about these terms later. Exercising Options People who buy options have a Right, and that is the right to Exercise. For a Call exercise, Call holders may buy stock at the strike price (from the Ca ll seller). For a Put exercise, Put holders may sell stock at the strike price (to the Put s eller). Neither Call holders nor Put holders are obligated to buy or sell; they simply h ave the rights to do so, and may choose to Exercise or not to Exercise based upo n their own logic. Assignment of Options When an option holder chooses to exercise an option, a process begins to find a writer who is short the same kind of option (i.e., class, strike price and optio n type). Once found, that writer may be Assigned. This means that when buyers exercise, sellers may be chosen to make good on thei r obligations. For a Call assignment, Call writers are required to sell stock at the strike pri ce to the Call holder. For a Put assignment, Put writers are required to buy stock at the strike price from the Put holder.

Types of options There are two types of options - call and put. A call gives the buyer the right, but not the obligation, to buy the underlying instrument. A put gives the buyer the right, but not the obligation, to sell the underlying instrument. Selling a call means that you have sold the right, but not the obligation, for s omeone to buy something from you. Selling a put means that you have sold the rig ht, but not the obligation, for someone to sell something to you. Strike price The predetermined price upon which the buyer and the seller of an option have ag reed is the strike price, also called the exercise price or the striking price. Each option on a underlying instrument shall have multiple strike prices. In the money: Call option - underlying instrument price is higher than the strike price. Put option - underlying instrument price is lower than the strike price. Out of the money: Call option - underlying instrument price is lower than the strike price. Put option - underlying instrument price is higher than the strike price. At the money: The underlying price is equivalent to the strike price. Expiration day Options have finite lives. The expiration day of the option is the last day that the option owner can exercise the option. American options can be exercised any time before the expiration date at the owner's discretion. Thus, the expiration and exercise days can be different. European options can on ly be exercised on the expiration day. Option Pricing Options prices are set by the negotiations between buyers and sellers. Prices of options are influenced mainly by the expectations of future prices of the buyer s and sellers and the relationship of the option's price with the price of the i nstrument. An option price or premium has two components : intrinsic value and time or extr insic value. The intrinsic value of an option is a function of its price and the strike price . The intrinsic value equals the in-the-money amount of the option. The time value of an option is the amount that the premium exceeds the intrinsic value. Time value = Option premium - intrinsic value.

Futures Trading - The Perfect Business? Futures trading is a business that gives you everything you've ever wanted from a business of your own. Roberts (1991) calls it the world's perfect business. It

offers the potential for unlimited earnings and real wealth, and you can run it working your own hours while continuing to do whatever you're doing now. You operate this business entirely on your own, and can start with very little c apital. You won't have any employees, so you wouldn't need attorneys, accountant s, or bookkeepers. In fact, although you'd be buying and selling the very necess ities of life, you never even carry an inventory. What's more, you'd never have collection problems because you won't have any "cu stomers," and since there is no competition, you won't have to pay the high cost of advertising. You also won't need office space, warehousing, or a distributio n system. All you need is a personal computer and you can conduct business from anywhere in the world.... Interested?... Please go ahead and read on! What is a Futures Contract? A futures contract is a standardized, transferable, exchange-traded contract tha t requires delivery of a commodity, bond, currency, or stock index, at a specifi ed price, on a specified future date. Generally, the delivery does not occur; in stead, before the contract expires, the holder usually "squares their position" by paying or receiving the difference between the current market price of the un derlying asset and the price stipulated in the contract. Unlike options, futures contracts convey an obligation to buy. The risk to the h older is unlimited. Because the payoff pattern is symmetrical, the risk to the s eller is unlimited as well. Dollars lost and gained by each party on a futures c ontract are equal and opposite. In other words, futures trading is a zero-sum pr oposition. Futures contracts are forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the da te specified in the contract. Futures are distinguished from generic forward con tracts in that they contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by clearinghouses. Also, in order to insure that payment will occur, futures have a margin requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed . Trading in futures is regulated by the Securities & Exchange Board of India (SEB I). SEBI exists to guard against traders controlling the market in an illegal or unethical manner, and to prevent fraud in the futures market. Futures Trading Futures contracts are purchased when the investor expects the price of the under lying security to rise. This is known as going long. Because he has purchased th e obligation to buy goods at the current price, the holder will profit if the pr ice goes up, allowing him to sell his futures contract for a profit or take deli very of the goods on the future date at the lower price. The opposite of going long is going short. In this case, the holder acquires the obligation to sell the underlying commodity at the current price. He will profi t if the price declines before the future date. Hedgers trade futures for the purpose of keeping price risk in check. Because th e price for a future transaction can be set in the present, the fluctuations in the interim can be avoided. If the price goes up, the holder will be buying at a discount. If the price goes down, he will miss out on the new lower price. Hedg ing with futures can even be used to protect against unfavorable interest rate a djustments.

While hedgers attempt to avoid risk, speculators seek it out in the hope of turn ing a profit when prices fluctuate. Speculators trade purely for the purpose of making a profit and never intend to take delivery on goods. Like options, future s contracts can also be used to create spreads that profit from price fluctuatio ns. Accounts used to trade futures must be settled with respect to the margin on a d aily basis. Gains and losses are tallied on the day that they occur. Margin acco unts that fall below a certain level must be credited with additional funds. Settling Futures Contracts Futures contracts are usually not settled with physical delivery. The purchase o r sale of an offsetting position can be used to settle an existing position, all owing the speculator or hedger to realize profits or losses from the original co ntract. At this point the margin balance is returned to the holder along with an y additional gains, or the margin balance plus profit as a credit toward the hol der's loss. Cash settlement is used for contracts like stock index futures that obviously cannot result in delivery. The purpose of the delivery option is to insure that the futures price and the c ash price of good converge at the expiration date. If this were not true, the go od would be available at two different prices at the same time. Traders could th en make a risk-free profit by purchasing goods in the market with the lower pric e and selling in the market with the higher price. That strategy is called arbit rage. It allows some traders to profit from very small differences in price at t he time of expiration. Pricing Futures Futures prices are presented in the same format as cash market prices. When thes e prices change, they must change by at least a certain minimum amount, called t he tick. The tick is set by the exchange. Prices are also subject to a maximum daily change. These limits are also determi ned by the exchange. Once a limit is reached, no trading is allowed on the other side of that limit for the duration of the session. Both lower and upper limits are in effect. Limits were instituted to guard against particularly drastic flu ctuations in the market. In addition to these limits, there is also a maximum number of contracts for a g iven commodity per person. This limit serves to prevent one investor from gainin g such great influence over the price that he can begin to control it. How do you fit in! In your futures business, you buy or sell futures contracts because you expect t o make a profit on the transaction. In fact, most futures & commodities traders have no use for the actual commoditi es they are trading; they never even see them. They are just people like you and me; people with a certain amount of capital to invest getting started in their own business. There are millions of them and they come from almost every profession: from cler ks to executives, from janitors to doctors, from students to university presiden ts. It is the millions of traders controlling the millions and millions of contr acts that allow the exchanges to exist. But more than that, we make it possible for farmers, dealers, and manufacturers to reduce their own risks. For performing this service, we expect to make a prof

it. The great thing about all of this is that you don't need a college degree or eve n a high school education to do well trading futures. However, you do need some training, you need an objective system, and you need a plan.