It has become of prime importance that students are aware of the various tools and techniques available to take advantage of the fluctuations in the stock market.
Investing is the heart and soul of any student and especially for a business student. Unfortunately, quite often we ignore the practical aspects of the stock market in our college days only to repent later on.
Options Contract is one of the simplest and yet tricky way to cash on the multiple avenues in the stock market without undertaking a huge risk. It is the basic which every investor must be aware of. Now without much ado, let us understand what an options contract is.
What Is An Options Contract?
An option contract is simply an agreement that gives the option buyer the right but no obligation(i.e isn’t compulsory) to buy or sell the concerned underlying security to the option seller for a pre-agreed strike price or quantity on or before the expiry date.
There are three important points that one needs to keep in mind:
- Strike Price– This is the pre-agreed price at which the buyer will buy from the seller before or at the end of the expiration date.
- Expiration Date– This is the date on or before which the deal should take place.
- Premium Price– This is the price that the buyer must pay to the seller beforehand (irrespective of the deal taking place in future or not) to obtain the right to buy the underlying security in the future. Basically, by paying the premium price, the buyer establishes the fact that he is a credible buyer.
Most Striking Characteristic
Also, it is to be kept in mind that the most vital feature of an options contract is that it’s optional. The buyer of the options contract has the right to either exercise his option of buying or not buying the concerned underlying security depending upon the suitability of the market conditions. The seller is obliged to sell or not sell as per the buyer’s wishes.
As mentioned earlier, do not forget that the premium price is to be paid at the beginning of the contract irrespective of the deal taking place in future or not.
Before I go on to explain it with examples, let us discuss a few more technical terms regarding it.
Various Types Of Options
There are two basic two types of options: call option and put option.
Call options are the type of option that gives the buyer the right, but not the obligation, to buy the underlying security at the pre-agreed price before or on the expiration date.
Basically, one will execute a call option when he/she is bullish about the market and expects the price of the security to rise considerably in the future.
Similarly, Put options give one the right, but not the obligation, to sell the concerned underlying security at a pre-agreed price before or on the expiration date. Put buyers are usually bearish on the market and expect to gain profit from the downfall of the stock price in the future.
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In a call options contract, a trader expects Company ABC’s stock price to go up to Rs. 80. The concerned person sees that he can buy an options contract of Company ABC by paying a premium price of Rs. 5 per share with a strike price of Rs. 50 per share.
The buyer must pay the option premium (5 X 100 shares = 500). Suppose, the stock price rises to Rs.100. Just before the expiration date, the buyer executes the call option and buys the 100 shares of Company ABC at 50. He pays 5,000 for the underlying security. The trader can then sell his new stock and make a profit on the difference by selling it for 10,000, making a 4500 profit (10,000-5,000-500).
Some things that are to be noted are:
Let’s suppose that the price of the stock plummets down to 30. In that case, the buyer will obviously not execute the option as he will be at a huge loss if he buys and sells it in the market. (3000-5000-500). Thus, he will not execute it and the loss incurred to him will only be the option premium price(compulsory) that he paid. (500)
So, we have come to the conclusion that the loss incurred to a buyer of the option can be maximum upto the limit of option premium price while the profit can be theoritically unlimited.(depending upon the final stock price)
Similarly, in the case of put options, the buyer makes a profit by cashing on the difference because of the fall in stock price.
So, basically like the Futures contract, these are ways to extract the maximum out of the share market and cash on.
Image Credits: Google Images
Sources- Investopedia, InvestorGuide, OptionTrading