Option Derivatives Concept Explain [BCS 13/15] Eng.

As we talked about in previous article, There are four types of derivatives – forward derivatives, Future Derivatives, Option Derivatives and swap derivatives.

In this article, we will discuss Option Derivatives in a simple and easy way, and understand its various aspects, So read this till the end.

Note – If you want to understand the basics of share market from zero level then you should start with Part 1. – Share Market and Related

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| What is Derivatives?

Any instrument that has no value of its own, but derives its value from something else. They are called derivatives.

The thing on which its value depends is called the underlying asset. As the value of paneer depends on milk, so here milk is the underlying asset of paneer.

There are four types of Derivatives – Forward, Future, Option and Swap. In this article we will understand option derivatives:

| What is Option Derivatives?

Before understanding this article, you must understand the future derivatives because it is also a type of futures contract, only some facilities and features have been increased in it.

In the article on Future Derivatives, we had read that it is a binding contract, that means once you have become a part of this contract, you cannot return till its expiry date. That is, you do not have any option to leave the contract in the middle,

But option derivatives, as the name suggests, in which you have an option that you can exit the contract whenever you want. What does it mean Let us understand it with an example.

| option derivatives example

Suppose you want a bike whose price is 1 lakh rupees. When you go to the showroom to pick up that bike, you come to know that that bike is not yet available in the market.

The manager of the showroom tells you that the bike will arrive in 2 months. You can buy that bike after 2 months but the showroom manager tells you that since the demand for that bike is very high, it may be that after 2 months when that bike comes in the market, its price will be 1 lakh 20 thousand rupees. In such a situation, after 2 months, you will have to pay an extra 20 thousand rupees.

To avoid this, the manager gives you an advice that you deposit 1000 rupees in advance so that even if the price of that bike increases after two months, you will still get it at today’s price. You booked that bike by paying 1000 rupees. This is called booking amount or premium.

⚫ It will happen that now no matter how much the price of the bike increases, you will get it for 1 lakh rupees. But in this contract, you have the option that if you want, you can also come out of this contract. Like if after 2 months, instead of increasing the price of that bike, if it decreases.

Let’s say that the price of that bike after 2 months is only 80 thousand rupees, in such a situation why would you want to buy it for 1 lakh. So obviously you will come out of this contract.

If you come out, you will only lose Rs 1,000 as the booking amount is non-refundable. Still you will get the benefit of 19 thousand because you are getting that bike in the market for only 80 thousand. Here is the basic concept of option derivatives .

| Types of Option Derivatives

There are two types of options – 1. Call option 2. Put option . Let us understand these two.

1. What is a Call Option?

Taking the above example only, what happened in this is that when we felt that the price of the bike is going to increase in the coming time, then after paying a small premium, we booked it at today’s price itself. This is what is called call option. The price at which we have booked it is called the strike price .

If the price of that bike really becomes 1 lakh 20 thousand after 2 months, then you will get a profit of 20 thousand. How? Because you got it only for 1 lakh but when you sell it now, it will be sold for 1 lakh 20 thousand, so there is profit of 20 thousand.

⚫ The price of that bike after two months has gone up to Rs 1 lakh 20, it is called the spot price . The person who buys the option in this contract is called the option holder and the one who sells the option is called the option writer.

⚫ You can apply this concept in the stock also when you think that the price of a stock is going to increase after a few months, then you can buy that share at today’s price (which is called strike price) on that day itself.

If its price actually increased on that day (ie the spot price increased) then you will gain and if it does not increase then you will lose only the booking amount.

⚫ For example, suppose the value of a share of Reliance is Rs 1000 in today’s date and you think that after 3 months its price will be Rs 1500, then instead of buying the share by paying full 1000 rupees, you can give it only 100 rupees for 3 months. Will book to buy later.

If after 3 months the price of that share really becomes 1500 rupees, then there will be a profit of 400 rupees. Why? Because you have filled the booking amount of Rs 100 and you have signed the contract on Rs 1000. That is, your total will go to Rs 1100, if the price of that share becomes Rs 1500 then. Still you will get a profit of 400 rupees.

⚫ But if the strike price at which you have booked that share, if the spot price goes below that i.e. you have signed the contract at the strike price of Rs 1000 but after 3 months if its spot price remains 500 then it is obvious. You won’t buy it.

Because if you buy it then you will have a loss of 600 rupees but if you don’t buy it then you will lose only 100 rupees.

Hope from this example you have understood why option is different from future. Let us now know some of its terminology.

| Option’s Terminology

⚫ If the spot price is higher than the strike price, then in such a situation we have an advantage. This is called in the money or ITM.

⚫ If the strike price and the spot price remain same, then in that case we will only lose the booking amount because the booking amount is not refundable. It is called ATM i.e. AT The Money .

⚫ Even if the spot price is less than the strike price, we will still lose our booking amount because then we will not buy it. Such a situation is called Out of the Money ie OTM.

⚫ But if the spot price increases by the same amount as the booking amount is added to the strike price, you will neither gain nor lose. This is called break even .

2. What is a put option?

Let’s try to understand with the example of this bike. Let’s say you already have a bike. And you are going to sell it after 2 months for 80 thousand. But if you think that it is only 2 months, do you know if the bike gets damaged in that time or if it gets accident and it breaks, then obviously it will not be sold for 80 thousand.

Thinking that you get a bike insurance for 1000 rupees that if the bike breaks down anytime within 2 months, then the insurance company will give you that amount.

⚫ It will happen that if your car breaks down within these two months, then you will get 80 thousand rupees from the insurance company, apart from this, if you have a bike, you will also sell it in junk, even then something or the other Then it will be beneficial. And if your bike doesn’t get damaged then you will lose as much as the premium of that insurance because the premium amount is not refundable. Overall, this is its basics.

⚫ If you apply this to the stock, then people buy put option when they think that the price of the share is going to fall in future. That is, in a call option, you profit when the price of that item goes above the strike price, but in a put option, the spot price goes below the strike price. Because you bought it because you think the market will go down. But if it goes up, then in that case you will lose as much as you have taken insurance.

Hope you have understood option derivatives . Now we will understand its last part i.e. Swap Derivatives in the next article. The link is given below-

Swap Derivatives

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