Introduction to options

Metal stocks set to boost your portfolio next year! Have you seen this headline recently and wondered about adding steel stocks to your portfolio? Did you just go to your investment app and search for the stock of Tata Steel? If yes, you must have seen a long list of items with names such as December call, December put, and other months’ options. If you have tried your luck at investing in the stock market, you would have heard of a variety of terms such as stocks, derivatives, options, futures, etc.

For many of us, just hearing these words can lead to confusion, but that need not be the case. While you probably already know that stocks or equities refer to the shares of companies which you can buy and trade for a profit, do you know what derivatives are? If you have a basic idea about these concepts, or even if you know nothing at all, we are here to help you clear your doubts. So let us get started by demystifying these concepts in the simplest way possible. Let us first talk about derivatives. As a financial product, which, just like its name suggests, derives or gets its value from another asset. Derivatives can be an exciting investment option.

Let us take a very simple example to start with. When your car's tank runs empty, what do you do? You drive to the nearest petrol pump for a refill. Here, you look at the electronic fuel meter, which displays the volume of petrol being filled along with the amount you need to pay. You know that the price of petrol changes from time to time. Have you ever wondered how they arrive at that price? The price you pay for petrol depends on the current price of crude oil, so one could say that petrol’s value is derived from the prevailing rates of crude oil. The concept of derivatives is quite similar. It is a financial instrument that has no value of its own; a derivative gets its worth or value from that of the underlying asset, which could be stocks, bonds, commodities, currencies, indices, or interest rates. Now that you know what a derivative means, let us look at some of its important features. Each time you refuel your car, there is a transaction between you, the buyer, and the petrol pump, the seller. The petrol pump sells you petrol for a specific price, and you agree to buy it at that price. A derivative contract also involves a transaction between a buyer and a seller.

Here are the key components of a derivative contract: lot size or contract size stands for the minimum number of units being exchanged; for example, a crude oil derivative may have a lot size of 100 barrels. The expiry date is when the derivative transaction must take place—you cannot trade the contract once the expiration date has passed. Price is the pre-agreed rate at which you will settle the contract. So how do you then trade derivatives?

Derivative contracts are mainly of two kinds:

1. Over-the-counter (OTC) derivatives:

These derivatives are traded directly over the counter between the buyer and the seller; there is no intermediary, so you and the other party are free to customize the contract terms.

2. Exchange-traded derivatives:

They are bought and sold through an intermediary known as the exchange, which links the buyers and sellers of derivatives. Here, the contracts are most standardized, so you have no scope for personalization.

Now that you're aware of derivatives, let us understand what options are:

An option contract is an example of an exchange-traded derivative instrument. Now let us look at what this concept means. Suppose you're planning on booking a hotel room for your vacation a month from today during the festive season. You know that the prices will go up in the next month, so you want to book in advance. However, what if the hotel does not receive any bookings and reduces its price in the meantime? You would be facing a loss since you have entered a contract to pay more. What could be a solution here? Options could be the solution to this problem. Options are a derivative instrument that gives rights to the buyer of an option, and the option seller has an obligation to honour the contract. Options contracts are different from futures contracts because one party has the right to buy or sell an underlying, while another party has an obligation; while in futures, both parties have an obligation.

• Call and put options:

  The right to buy is a call option, while the right to sell is a put option. Options contracts provide the buyer with the option to exercise their right to buy or sell, as the case may be. The buyer may choose to exercise their right only if it is favourable. If a transaction is not in the buyer's favour, they're not required to go through with it. On the other hand, the seller doesn't have any right but has an obligation. If a buyer wants to exercise their right, the seller must compulsorily oblige and honour the contract. The buyer of an option is also known as the holder; the seller of an option is also known as the writer. So, in a hotel example, you can buy a call option with the hotel to stay at your booked rate despite an increase in prices. However, if the price falls, you are not liable to check in at your booked price. Similarly, if you expect a fall in price and want to sell at your earlier agreed price, you can buy a put option.

• Premium:

  To enjoy this right of buy or sell, you would have to pay a premium, as the party with the right has to compensate the party with the obligation. So, when a buyer purchases their right, they need to pay the cost of that right, known as a premium, upfront to the seller. This means that the buyer needs to make an upfront compensation to the seller for taking on risk. Since the hotel is taking on a risk by agreeing to your price, you need to compensate them with a premium, because you may choose to cancel your stay if the hotel price falls at the time of the trip, which will lead to a loss for the hotel. That's why options are always a zero-sum game; that is, profit for one party is equivalent to the loss for the counterparty.

Let us look at examples of market-based call and put options to understand the concept better. Assume you are bullish on ABC Limited stock and have purchased the ABC Limited ₹1000 call option with an expiry of January 29th at ₹100. This means that you have purchased the right to buy ABC stock at ₹1000 on expiry. You don't need to exercise or use your right compulsorily; you can exercise your right only if it is favourable to you. For instance, if you find that the ABC Limited’s market price is more than ₹1000, you can choose to exercise your call option. The amount you paid to purchase the right is known as premium—that is, ₹100 in this example. The rate at which you enter the contract is known as the strike price or the exercise price—that is, ₹1000 in this example. If you don't exercise your right, you will lose the premium to the seller, who will earn it. However, if your expectation turns into reality and ABC Limited stock touches ₹1300, then you have the right to buy the stock at ₹1000 and earn a profit after deducting the premium paid. The level at which you start earning profits is known as your break-even point.

Let us understand the put option now. Assume that you have purchased the ABC Limited’s ₹1000 put option with an expiry of January 29th at ₹80. This means you have purchased the right to sell ABC Limited at ₹1000 on expiry. You don't need to exercise your right if it is not in your favour; you may exercise your right only if you find that ABC Limited’s market price is less than ₹1000. In this case, if you don't exercise your right, you will lose the premium to the seller, who will earn it. But suppose ABC Limited does fall below ₹1000, as you expected. Then you can earn a profit from exercising your right to sell the stock at ₹1000. Now that you have a fair idea of what derivatives and options mean, do you think this is a call you want to take?