Question :What are Options?

Answer :Options are derivative products which, if you buy, give you certain rights.

Question :What kind of rights?

Answer :Call Options give you a right to buy a share (at a certain specific price), while Put Options give you a right to sell (again at a predefined price). For example, if you buy a Satyam 240 Call Option, you are entitled to buy Satyam shares at a price of Rs 240 per share. This specific price is called as the strike price or the exercise price.

Question :What do I pay for obtaining such rights?

Answer :The cost you pay for obtaining such rights is the premium (also called price or option value). In the above case, if you had paid Rs 20 for the Option, that would be the premium.

Question :So do I actually get Satyam shares?

Answer :Most of the time, you do not even intend to buy Satyam shares. The option itself has a value that keeps fluctuating with the price of Satyam shares. For example the Satyam share price may have been Rs 242 when you bought the Call Option.

You expect Satyam price to rise. You accordingly bought the Call (instead of Satyam itself). Now if Satyam rises to Rs 270 (in 10 days time), you will find that that the Call would also have risen in price from Rs 20 to Rs 35. In that case, you would simply sell the Call for Rs 35. You would have made a profit of Rs 15 on the Call itself without getting into Satyam shares themselves.

You can get Satyam shares (through the Call) if you want to, but that we will discuss later.

Question :So when should I buy a Call?

Answer :You should buy a Call when you are bullish.

Question :Why should I not buy the share itself?

Answer :Well, you can. But in Options you will earn more. Take the above case. If you buy Satyam shares at Rs 242 and sell Satyam at Rs 270, you will make a profit of Rs 28, a 12% return. Now if buy the Option at Rs 20 and sell at Rs 35, you have earned 75% return.

Your view is on Satyam in both cases, for the same period of time and you earn far more in Options.

Question :What if my view is not correct?

Answer :Here again, Options are very useful. If your view is wrong, you will find that your Option value will decrease, as Satyam share price decreases. For example, you will find that the Option value is only Rs 10 if Satyam drops to Rs 225. In that case, you will sell off the Option at Rs 10 and bear the loss.

If you had bought Satyam, you would have lost Rs 17 per share, while here you lose only Rs 10. It is however higher in percentage terms.

If Satyam drops all the way to Rs 200, you will find that your Option carries virtually no value. Here again, you would have lost Rs 42 per share in Satyam. But in Options, your maximum loss will be Rs 20, i.e. the amount you paid for buying the Option.

The biggest advantage of Options is that your maximum loss is limited to the Option Price you paid. Hence, you have limited losses but unlimited profits as a buyer of Options.

The accompanying graph is very useful in understanding the profit / loss possibilities of an Option. The X-axis shows the price of Satyam and the Y-axis indicates the profits or losses you will make.

How can I enjoy such a wonderful profile of limited losses and unlimited profits? I mean, somebody must be paying for this, isn’t it?

Well, you are right. That somebody paying for this is the Option Seller (also called the Option Writer).

Question :Why does he pay for unlimited losses?

Answer :The Option Writer is usually a skilled market player with an indepth knowledge of the market. He is willing to take unlimited risk in return for a limited profit. The premium you pay is his limited income, but if his view is wrong, he will pay you for the unlimited profits you might make.

In the above case, if Satyam share price rises the Option Seller will lose Rs 15 (he would have sold you the Option at Rs 20 only to buy it back at Rs 35). If Satyam rises further, the Option value will also rise and his losses will be that much higher.

Question :When will the Option expire and what happens on expiry?

Answer :Options will (like Futures) expire on the last Thursday of every month. On expiry, your Call Option will be settled based on the closing price of Satyam. For example, if Satyam share price was Rs 281 on the last Thursday, you will be paid Rs 41, i.e. the difference between Rs 281 and your strike price of Rs 240.

Your net profit will be Rs 21, i.e. Rs 41 that you receive on expiry less the Rs 20 premium that you paid for purchasing the Option.

Question :Who will pay this difference of Rs 41?

Answer :The Option Seller/Writer will pay this difference of Rs 41 to the exchange which will pay your broker who will pay you.

This settlement is called automatic exercise of the Option.

Question :What if the price of Satyam on the last Thursday is below Rs 240?

Answer :If Satyam closes at say Rs 237, you will receive nothing. In that case, your loss will be Rs 20 (your premium) which the Option Seller would have earned as his income.

Question :Can I also exercise before the expiry date?

Answer :In case of stock Options (31 stocks currently), you can exercise your Option on any trading day. You will receive the difference (if you are holding a Call Option) between the closing price and your strike price. Such Options which can be exercised at any time are called American style Options.

In case of index Options (2 indices currently), you can exercise only on the last day. These are called European style Options.

Question :Are American style Options more useful / flexible?

Answer :Yes, but only partly. The advantage of anytime exercise is useful for Option buyers. However, in practice, exercise is rare. You will find that it is more profitable to sell an Option (having bought it earlier) rather than exercise.

You will often receive more by sale than by exercise. If you are waiting in the Ground Floor of a building and want to go to the 21^st floor, you have two Options – one – take a lift and – two – take the stairs. Which will you prefer? Obviously the lift. In a similar manner, having bought an Option, you can exit in two ways – one – sell the Option and – two – exercise the Option. More than 95% of buyers will sell the Option.

Question :So when should I exercise?

Answer :You will take the stairs only when the lift is not working. In a similar manner, you will exercise the Option only when the sale possibility is not working. If the market is illiquid and you find that there are no trades happening, you may try to exit through the exercise route.

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