Meaning,Concept & Example of Options Contract

 

It is important to understand the derivative first before reading about the meaning,concept & example of an options contract-

 

Derivative:

To make its meaning understandable, let me start up with an example “Curd is a derivative of Milk” which means the price of the curd would depend upon the price of the milk.

However in Financial Market, Derivatives are one of the forms of trading in the secondary market. “These are the financial instruments which derive their value from one or more underlying assets”.

The Underlying asset could be stock, bonds, currencies, indices, commodities etc. Derivative instruments are the legal contract where an exchange is the guarantor and all the specification like price, validity, quantity, quality, rights & obligations of participants are predefined and binding.

 

Options Contract:

Options are one of the Derivative Contract which gives buyer the right but no obligation to buy or sell the underlying security for a pre-defined price or quantity on or before the specific date. So unlike the future contract, there is no obligation in option contract to honour the contract. You buy the right to honour the contract for a price called Premium. Call Option and Put Option are the two ways of trading in an option derivative contract where the trading is done on premium amount.

This can be well explained as:

Buy Call Option: When an investor is of the opinion that the market will go up.

Sell Call Option: When an investor is of the opinion that the market will go down.

Buy Put Option: When an investor is of the opinion that the market will go down.

Sell Put Option: When an investor is of the opinion that the market will go up.

Buy option gives an unlimited potential for the profits and with an advantage of limited loss while the sell option gives a limited potential for profits but the losses are significantly high or unlimited.

 

For Example:

Call Option:

Buy call option of NIFTY at Rs 5400 whose spot price is Rs 5500 at a premium of Rs 50 where a lot size is of 50 which means that an investor had paid Rs 2500 only and hold a position for Rs 2.70 lakhs. Now let’s take the bullish scenario where the closing price of NIFTY at expiration is Rs 5600, here an investor will make a profit of Rs 7500((5600-(5400+50))*50). On the other hand if the market goes down to Rs 5100, here an investor will lose only Rs 2500, the premium amount he had paid at the beginning of the contract and will not buy at the expiration as he is not obliged to do so.

 

Put Option:

Buy put option of NIFTY at Rs 5400 whose spot price is Rs 5500 at a premium of Rs 25 where a lot size is of 50 which means that an investor had paid Rs 1250 only and hold a position for Rs 2.70 lakhs. Now let`s take a bullish scenario where the closing price of NIFTY at expiration is Rs 5600, here an investor will make a loss of Rs 1250 only which is the premium amount which he had paid at the beginning of the contract and will not exercise his put option as he is not obliged to do so. Now take the situation where market goes to Rs 5200 at an expiration, here an investor will make a profit of Rs 8750((5400-25-5200)*50).

 

Do you like it, would you like to read:

What are Future Contracts | Difference between Effective & Nominal Rate of Interest | What are Forward Contracts.

 

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