Option represent another derivative instrument and provide a mechanism by which one can acquire a certain commodity or other asset, or take positions in order to make profit or cover risk for a price. The options are similar to the futures contracts in the sense that they are also standardized but are different from them in many other ways. Options represent the rights.
An option is the right but not the obligation to buy or sell a specified amount or quantity of a commodity, currency, index, or financial instrument, or to buy or sell a specified amount of underlying futures contracts, at a specified price on or before a given date in future. Like other contracts, there are two parties to an options contract: the buyer (the holder or owner) and the seller. Buyer takes the long position and seller takes the reverse means short position. The options contract gives the owner a right to buy/sell a particular commodity or other asset at a predetermined price by a specified date. The price involved is called exercise or strike price and the date involved is known as expiration date. It is important to understand that such a contract gives its holder the right, and not the obligation to buy/sell. The option writer, on the other hand, undertakes upon himself the obligation to sell/buy the underlying asset if that suits the option holder. The notion of options can exemplify as follows.
Suppose one goes for shopping in a market, and in a certain store he see an article, say a carpet, which he likes. However, he does not have the full amount to pay for it. He asks the manager to keep some money as advance so as to allow him to buy the carpet within the next three days, and manager agrees to the proposal. Now, he may or may not go to the store to buy the carpet within the specified time. Suppose, he finds an identical carpet at a lower price in another store, he may simply forget about the first one. Here he has an option to buy – he is not obliged to buy. However, the manager is obliged to sell the carpet. Similarly, suppose that one buys some goods which are covered by a warranty so that he is given liberty of returning them back within a specified period of time, with a refund of the price paid in case he is dissatisfied with them in any way. Forget for a while that he has bought the goods originally and concentrating only on the right to send them back, eh has the option to sell the items back, but he is not obliged to de so. The company to buy back, if he so desired. |
A call option gives an owner the right to buy while a put option gives its owner the right to sell. There is a wide variety of underlying assets including agricultural commodities, precious metals, shares, indices, and so on, on which options are written. Further, like futures contracts, options are also tradable on exchange, the exchange-traded options are standardized contracts and their trading is regulated by the exchange that ensures the honoring of such contracts. Thus, in case of options as well, a clearing corporation takes the other side in every contract so that the party with the long position has a claim against the clearing corporation and the one with short position is obliged to it. However, while buying or selling of futures contracts does not require any price to be paid, the options are bought and sold on the exchange for a price, called the premium. The writer of an option receives the premium as a compensation of the risk that he takes upon himself. The premium belongs to the writer and is not adjusted in the price if the holder of the option decides to exercise it. This price is determined on the exchange, like the price of a share, by the forces of demand and supply. Further, like the share prices, the option prices also keep on changing with passage of time as trading in them takes place.
One difference between futures and options trading may be noted. Whereas both parties to a futures contract are required to deposit margins to the exchange, only the party with short position is called upon to pay margin in case of options trading. The party with the long position does not pay anything beyond the premium.
When an option contract is bought, it is up to the holder to exercise it or not, and the writer has no say. To illustrate, suppose it is June now and an investor is considering buying August contract on Reliance Industries Ltd. (RIL) involving 600 shares with an exercise price of Rs. 540. If it is a call option, the investor obtains, on purchase of the option, the right to buy shares of RIL at the rate of Rs. 540 per share on the expiration day stipulated in the month of August. Obviously, if on that day, the price of the share in the market is quoted at higher than Rs.540; the investor would like to exercise the call. By buying shares at Rs. 540 and selling them at the prevailing price, the investor can make a profit. If, on the other hand, the price of the share is quoted at Rs. 540 or lower, the investor would not exercise the call as it would amount to buying shares costlier than the market price. In any case, the writer of the call option is obliged to sell the shares at Rs. 540 per share, if call upon.
Now, in case the option happens to be a put option, it would give the investor the right to sell 600 shares of RIL at Rs. 540 per share at the expiration date, to the writer of the option. The investor would naturally be inclined to exercise the option if the share price on the stipulated date happens to be lower than Rs. 540. By buying the shares in the market at a rate lower than Rs. 540 per share, and selling them at Rs. 540 per share, the investor would stand to gain. In this option, the writer would be obliged to buy the shares at a price of Rs. 540 per share in case the holder of the option opts for that.
It is not necessary to hold an option until the maturity. Buying an option, after all, is like buying a ticket for, say, a cricket match. Once you buy a ticket, you may decide to watch the match on the stipulated day (which exemplifies exercising your option), not to go the match venue in which case the ticket goes waste (this is not exercising your option and letting it expire), or you may sell the ticket before or on the match date. Accordingly, the option holder can keep the option till expiry or sell it in the market anytime before it expires. Option markets are highly liquid, generally.
While we have talked about options contracts which are traded on exchange, there are salutations when such contracts may be entered in to privately by parties. For example, institutions sometimes do need to enter into such contracts when they need a product with characteristics not available in exchange traded products. Such contracts are thus not standardized and have unique characteristics. Such over-the-counter options are generally not liquid and their trading is not regulated. |
