All about Derivatives

Watch this informative video to learn about exchange traded commodity derivatives

Take a long call on company X's stock now. This is a tip shared by a trading platform that Rajiv uses. Seeing such tips makes him confused because he's unable to make sense of the advice given out by experts. Sure, Rajiv has taken the right call by signing up for investment advice, but without understanding the meaning of long call and put, there is no way he can trade options properly. Honestly, Rajiv is not alone. While he knows that going long on an option means to buy it, and going short on it means to sell the option, going long on a put option and going long on a call option carry different connotations.

Are you as confused as our friend Rajiv? Don't worry, let us clear up these aspects. We will explain call and put options trade positions. As you know, there are two kinds of options available in the derivatives market: call options and put options. A call option is the right, not the obligation, to buy an underlying asset at an agreed price on a particular date. A put option is the right, not the obligation, to sell an underlying asset at an agreed price on a particular date.

Now, when you go long on call options, you become a buyer of that option. This means that a long call option gives you the right to buy the underlying asset, but not the obligation. Going long or buying a call option means the buyer will have to pay an option premium to the seller of the option. The seller here is going short on the call option; the seller has to sell if the buyer exercises their right.

Now, let's understand each of the option positions in detail.

Understanding Long Call:

If Rajiv is very bullish or positive on the asset, then he should choose a long call position. Let's understand this with an example. Suppose Rajiv has purchased Company X's call option with a strike price of ₹1000 at a premium of ₹50. This means that he has purchased the right to buy Company X's stocks at ₹1000 on expiry and has paid ₹50 to the seller of the option. He may prefer to buy if the market price is favourable, that is, if the price is more than ₹1000.

Let us look at three scenarios within this example:

Scenario One:

Company X closes at ₹1200 on expiry. As you know, all options close at their intrinsic value at expiry. In this case, Rajiv will get an amount equal to the intrinsic value of the call option, that is, spot price minus strike price; ₹1200 - ₹1000 = ₹200. Having paid ₹50 to buy the call option, his net profit will be ₹200 - ₹50 = ₹150. In other words, it is better to exercise the right, as you are getting the stock of X at a price lower than the current market price. In this example, we do not include the transaction cost while calculating the profit or loss.

Scenario Two:

Company X closes at ₹800 on expiry. In this case, it would make sense not to exercise the call option, as the current market price is lower than the agreed price of ₹1000. It would be better to buy the stock from the market rather than from the seller of the call option. Rajiv will lose the premium paid, which is ₹50 in this case. You can also calculate the profit or loss with the help of option buying and selling prices. The selling price of the option on expiry is equal to the intrinsic value of the option: intrinsic value = spot price - strike price; ₹800 - ₹1000 = -₹200. As you know, intrinsic value cannot be negative, so it will be considered as 0, meaning the buyer will receive nothing for this option at expiry, and he loses his buying cost of ₹50. Please note that the loss in the long option position will not be more than the premium paid.

Scenario Three:

Company X closes at ₹1050 on expiry. In this case, Rajiv may prefer to exercise his right and purchase at ₹1000. This will mean a profit of ₹50, but the net profit would be zero as he has paid ₹50 initially to purchase the option. This point is also known as the break-even point.

The payoff in various scenarios is listed down:

Okay, so now that you understand long call, let us look at the flip side, which is the short call. Rajiv knows going short means to take a position to sell, but what does that really mean?

Understanding the Short Call:

A short call is an obligation to sell an underlying asset to a call buyer at the strike price if the call option is exercised by the buyer of the option. A short call position or call option writing is useful when you are somewhat bearish or negative about the market. This means that you expect the underlying asset to stay in a narrow range, that is, either stick to its current price or show slight downside movement.

If Rajiv has to go short on Company X's option, it means he can sell the call option with a strike price of ₹1000 and earn a premium of ₹50. This move means he has an obligation to sell Company X at ₹1000 at expiry if the buyer exercises their right and receives ₹50 from the buyer of the option to fulfil his obligation. The buyer will prefer to exercise his right if it is favourable to him, that is, if the price is more than ₹1000.

Let us look at three scenarios within this context:

Scenario One:

Company X closes at ₹1200 on expiry. In this case, the buyer would prefer to exercise his right and purchase Company X at ₹1000. This means Rajiv will need to sell it at a discounted price of ₹1000 compared to the market price of ₹1200. He will incur a loss of ₹200 minus ₹50 (premium received) = ₹150 on this position. In other words, the option premium on expiry equals the spot price minus the strike price: ₹1200 - ₹1000 = ₹200. As we have a short position to square off, you need to buy the option at ₹200 that you sold at ₹50. This means your loss is ₹200 - ₹50 = ₹150.

Scenario Two:

Company X closes at ₹800 on expiry. In this case, the buyer won't prefer to exercise his right and won't purchase at ₹1000. This means he will lose the premium paid, incurring a loss of ₹50, which Rajiv will gain. Again, let's understand this from the difference in buying and selling prices. The option's intrinsic value, which is 0 in this case, is the buying price, and as the selling price is ₹50, the seller's profit is ₹50 - ₹0 = ₹50. Please note profit here is limited only to the premium received.

Scenario Three:

Company X closes at ₹1050 on expiry. In this case, the buyer will prefer to exercise his right and purchase at ₹1000, which means a loss of ₹50 for Rajiv, but this will be compensated by the premium received, so there won't be any profit or loss in this case.

Now, what do we understand from these scenarios? You should go with a short call when you expect a slight downfall in the market or expect the market to stay at the current level.

The payoff in various scenarios is listed here:

If you think the market is going to rise sharply, then a long call would be the best choice. Okay, now you know the difference between long call and short call and when to exercise these options.

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A currency option provides you with a right tool but not the obligation to buy or sell currency at a specified rate on a specific future date. In exchange for this right the holder usually pays the cost that is known as the premium for the currency option. Currency market fluctuations can have a lasting impact on cash flow, whether it is buying a property, making an investment, or settling invoices. By utilizing Forex options, businesses can protect themselves against adverse movements in exchange rates.

This feature of Forex options makes them extremely useful for hedging forex risk when the direction of the movements in exchange rates is uncertain. Forex options are also useful tools which can be easily combined with Forex Futures to create bespoke hedging strategies. Forex options can be used to create bespoke solutions and work to remove the uptrend cost of a premium.This involves certain caveats around the structure of the option product.

Now, let us understand some basic terminologies of Forex options:

Premium

The upfront cost of purchasing a currency exchange option is called the premium.

Strike price

The strike or exercise price is the price at which the option holder has a right to buy or sell a currency.

Expiry date

The trades expiry date is the last date on which the rights attached to an option may be exercised.

Exercise

The act of the option buyer notifying the seller that they intend to deliver on the option contract is called exercise.

Delivery date

The date when the currency exchange will take place if the option is exercised.

What is Option?

An option is a type of derivative instrument that involves a contract between two parties to buy or sell something on a future date, at predetermined prices. The contract gives the right, but not the obligation, to the buyer of the option, to buy/sell an underlying asset.

How to do Options Trading?

There are two types of options- Call option and Put option.

• What is Call Option?

The call option gives the right, but not an obligation, to the buyer of the contract to buy an underlying asset at a predetermined price (known as strike price), on the contract expiration date. The buyer typically exercises the call option when the market goes above the strike price.

• What is Put Option?

The put option gives the right, but not the obligation, to the buyer of the contract to sell an underlying asset at a predetermined price (known as strike price), on the contract expiration date. The owner usually exercises the put option when the market moves below the strike price.

Options Trading Benefits

• Less risky than future trading for an option buyer.
• Helps you to hedge your open position.
• Less margin required for Option buyers, who need to pay only premium as an up-front margin.

Who can trade in Options?

Options trading is open to all new and existing ICICIdirect trading account holders.

How can I trade in Options?

Login to ICICIdirect>F&O>Place your order.