HOW SHOULD I UNDERSTAND AN OPTIONS CONTRACT ?
Before we understand what is an options contract let us first understand a contract. A contract is an agreement between two parties. One party makes an offer and if the other party accepts the offer you have an agreement. Then what is a contract? When this agreement is given a legal standing by registering it becomes a contract. Your options contract is also a contract, where there is an offer and an acceptance.
Let us quickly touch upon an option
An option is a choice. When you have an option, you have a choice either to do something or not to do something. We will extend this argument to options in the stock market. But for that; let us step back into equities. Let us say you want to trade in Reliance at the current market price of Rs.1900. If you buy the stock at Rs.1900 and the stock goes up you make a profit but if it goes down you make a loss. In short, when you buy the stock, you can make a profit or a loss.
Suppose, I told you that you can enter into a contract with me today to buy the stock of Reliance after 1 month. At the end of 1 month, you can decide based on the price movement whether you want to buy or not? That sounds too good to be true. That is an options contract, because you have a choice at the end of the period whether you want to buy or not to buy the stock.
But who would be so generous to give me a choice?
The option sounds great but you are suspicious. Why should somebody give you this option to decide whether you want to buy or not at the end of 1 month free of cost? The answer is that the other person is not doing it free of cost. Since you are getting a choice in this case, it is a right without an obligation. For this right without obligation, you pay a price to the person who gives you this privilege. That price is called the option premium or option price. So when we talk of options price or option premium later, remember it is the price you pay for the right without obligation. This is the basis of an options contract.
Where is the Options contract signed?
We are talking of exchange-traded options which are standardized options. You do not have to enter into a contract each and every time. When you open your trading account with your broker and sign the agreement, the contract automatically comes into place. Each time you buy or sell options in the F&O market, you are automatically bound by the contract with the broker and the rules and regulations of the stock exchange. When you buy an options contract on the NSE, your contract is with the exchange and not with any individual.
What are the components of the options contract?
By now, you are pretty clear that an option is the right without an obligation to buy any asset. So you want to buy 1000 shares of Reliance but don’t have the funds or you don’t want to commit funds. You can buy an option to buy Reliance (call option). At the end of the period, you can decide whether you want to actually buy or not. But you have to pay a small price for this right which is called the option premium or option price. Now let us understand this call option practically.
Image 1. Data Source: NSE
Here we have a live call options contract on Reliance Industries. That means; it is the right without an obligation to buy Reliance. What is expiry date?
In the above illustration, expiry date in options is the last Thursday of every month. That right to buy Reliance will actually expire on 28-Jan 2021. Before that you can just sell this call option when you get profits and come out. If you don’t do anything till 28-Jan, then on that date, the exchange will automatically close your position. Any profit will be credited to your account.
Most important; what does the strike price mean?
You can see the strike price of Rs.2,000 in the above options contract. That means; this option is a right without an obligation to buy Reliance at a strike price or contract price of Rs.2,000. Obviously, you will be hoping that the price of Reliance goes well above the Rs.2,000 so that you make profit. Let us look at 2 scenarios.
- In the first scenario, if the price of Reliance closes on 28-Jan at Rs.2,075 then this option is valuable and you will make profit on the option. You will earn Rs.75 but you have paid a premium for getting this right. The difference is your profit.
- In the second scenario, if the price of Reliance closes on 28-Jan at Rs.1,900 then do you make a loss of Rs.100? No, you don’t. Remember, this is an option where you have a right but no obligation. However, the premium or option price paid is lost by you. That is the risk you take when you buy an option.
Image 2. Source : Rocket Trading Platform. To be a guest user visit https://rocket.tradeplusonline.com/
Where is the option price / option premium in the chart?
Now we come to real options trading. If you have to buy a Reliance 2000 call option expiring on 28-Jan, how much do you have to pay. Look at the prices shown in the last row of Image 1. That is the options price. An option is traded like a stock in the market. What happens in the two scenarios we discussed?
In the first scenario, Reliance has moved to Rs.2,100 on expiry day. You have a profit of Rs.100 (2,100 – 2,000). But you have paid Rs.48.60 as option premium. So your net profit is Rs.51.40.
In the second scenario, Reliance has fallen to Rs.1,900 on expiry day. You will not exercise the option and let it go. However, Rs.48.60 you have paid for the right without obligation will be your loss.
That, in a nutshell, is what options contracts are all about. There are put options that give a right to sell, but we will leave it here for now and learn this in the next chapters!
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