Puzzle we left off with in the last edition:
A colleague made a whopping Rs. 15,000 in one day by trading in options. He did so without exercising the option. Any guess as to how he did it?
Before answering that we missed one term in the last edition.
Strike price: In our example of land, the strike price was Rs. 5 lakhs - we told the seller that we are paying this premium to buy the land for Rs. 5 lakh at a later date.
So how did my colleague do it?
Let's say we have a stock which trades at Rs. 3800. My friend feels that this price is surely going to rise in a month - possibly to somwhere around Rs. 4100 and so he checks on what options are available for that stock.
He finds one with a 1 month duration with strike price of Rs.4000.
There are people who are willing to take a risk and sell options - they feel the opposite - that the stock price will go down further - so they want to make some money through premiums. Now there are a group of potential buyers - and they would kind of bid against one another to buy the option. It is all based on supply and demand - many people want to buy means that many feel the price will go up - and since demand is more the premium price will also go high.
Let's say the premium was Rs.50 per share (not many people expect that it will go up by 200).
Options are sold in lots (i.e. in bulk amounts of 100 or 200 shares). So my friend buys the option for 200 shares at a premium of Rs. 50 per share. Total money he pays is Rs. 10,000.
So he has bought options for a stock at a strike price of Rs. 4000 with a premium for Rs. 50 - which means he expects the stock price within one month to rise above Rs.4050 (only then will he make some profit).
On Monday due to some positive news in the market the stock price climbs up to Rs.3900 ?(up by Rs.100). Now more people start realizing that this stock could well cross the 4000 mark and so they scamper to buy the option at strike price of 4000. Since buyers are more the premium goes up. It might have gone up from 50 to 150 per stock since people now feel it might really shoot up.
My friend now has two options - wait till the price crosses the 4000 mark and then exercise the option. So if at the end of the option duration the stock price is 4001 then he makes a profit of Rs.1 per stock. Total profit = Rs.1 * 200 = Rs.200
Or he could square off his position - meaning that he now sells the option to someone else; since the premium is now 150 (while he gave a premium of only 50) he makes a profit of 100 per stock. Total money made = Rs.100 * 200 = Rs. 20,000.
Wow you say; that's a quick way to make huge amount of money. Everything is not rosy of course - on the downside; suppose my friend sells his option and at the end of the duration of the option the markey price might have become 4500.
Now the person who bought the option from my friend will think, "I paid 150 as premium for a strike price of Rs. 4000. So effectively I will make profit when the market price crosses 4150 mark. Now it is 4500 which meanuls I make a profit of 350 per option for a total of Rs.350 * 200 = Rs. 70,000". So the guy sees that he can make a huge profit and will enforce (exercise) the option. Since my friend was the seller of the option he has to either buy 200 stocks from the market and give it to the buyer at the rate of 4000 or he has to pay the Rs. 70,000 difference between current market price and strike price.
ERRATA (21 August 2007): There's a catch; in the above case my friend will not have to pay the other guy - instead it will be the first guy who sold the option who will be held liable. Whenever one does a buy and sell of an option (square off) then you are not considered as being the creator of the option. If you sell an option without having bought it then you are the initiator of the option - this is possible and this is how options originate. How can you sell without buying? An option just means that you are telling a person "give me an advance now and I shall guarantee to give you the stock in future at the strike price irrespective of the market price at that time". So you can sell an option without ever buying one but in this case you end up with unlimited liability. If my friend had sold the option without having bought it he would've been exposed to unlimited liability and will need to pay the 70k.
So you can see that the losses are unlimited for the seller of options but for the buyer the worst case would be losing his premium if he finds that the prices are going in an unfavourable direction.
And that is similar to what my friend did to earn a large sum in 2 days.