FO What is an option?

Posted by Anand Kumar on 19 January 2010
Last update on 3/7/2010 12:00:00 AM. Total replies 2

Option as the name suggests is an option.

What is an Option?

As the name suggests it is an option. One of the 2 parties taking part in the option contract has the option to honor or neglect the contract.

Person A and Person B enters an option contract where Person A has the option to buy Stock A at Rs. 150 Called as strike rate on a fixed date from Person B. Usually active strike price will be higher than the market price of Stock A.

Why person B should enter the contract?

For each strike price contract there will be a premium Which Person B decides which Person A has to give person B to enter into this contract which is non returnable.

Example: Anand enters a options contract to buy 1000 shares of HUL from Dakhsh at Rs. 260 Current rate Rs. 255 on 25 February 2010 Current date: 18-Jan-2010 by paying Daksh a premium of Rs. 5 per share.

results: If HUL closes at 260+ on 25th Feb 2010 Anand will ask for delivery.

Else Anand will ignore the contract. Daksh gains Rs. 5.

Till HUL closes below 265 Dakhsh is in profits. Because he has already received Rs. 5 and he will again receive 260 if deal is executed.

Anand makes profits if HUL closes above 265.

Advantage to Anand is his maximum loss is known Rs. 5000 in this case.

Advantage to Dakhsh: He can make a profit of Rs. 5000.

Risks to Person B: Losses can be unlimited.

When losses can be unlimited why Dakhsh may enter this deal?

There are different strategies followed by investors and traders using options and futures.

Consider the following situation.

I own 1000 shares of HUL purchased at 235 with a target of Rs. 260. In this case it is most likely that I will sell HUL if it touches Rs. 260 mark.

Now I will sell a lot of HUL at 260 strike in options at a premium of Rs. 5. Now I absolutely have no risk as whatever rate HUL reaches I can honor the contract as I have delivery stocks.

I can keep doing this forever till I sell HUL. May be in a year I can do atleast 5 such successful transactions without loosing my stock. This will take my selling price up to 285 whenever the deal is honored.

People do enter into combination deals like buying a lot of future and selling a option call.

Or selling a low strike price call and buying a high strike price call etc.

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Posted by Suraj Bekal on 6 March 2010

Anand Bhai... i really don't know why but for me no matter how many articles i read on futures and options, it just doent enter my head.

Nice reading but I am better off with equity.. lolz