Wednesday, April 04, 2007

What is the option in options? How options work?

Just thought of writing a series on the stock markets, finance and related concepts - hope you enjoy the series...Stock market terminologies are bolded

What is the option in options? How options work?

You must've heard of derivatives with respect to te stock market; Futures and Options (F&O as they are called) are a form of derivative. We'll take a look at that later.

So let's say there is a piece of land up for sale. Owner demands 5 Lakhs. You really want to own that property but can't afford it right now. You want to buy it after a couple of months. But the owner is bound to sell it to someone else by then - after all, everyone is into real estate business now. So you talk to the owner and tell him, "I really want to buy this land in a couple of months".
Owner: I can't keep waiting for two months; what guarantee do I have that you will buy it after 2 months. Two months is a long way away.
After a long pause the owner says, "Ok, we'll do one thing. You pay me an advance amount now - like a reservation fee to block the land for you. If you don't buy it then at least I would get the reservation fee".

"And if you do buy the land, then I'll give it to you for the same price of Rs. 5 lakhs itself irrespective of the market price at the end of two months".

This sounds a fair enough deal. We pay a non-refundable advance to the owner and at the end of the second month we have the option to buy the land at the current price. We have a gut feeling that the price of the land will most likely shoot up by 2 months.

Note: It is an option given to us by the owner and not a compulsion for us to buy the land at the end of two months. Let's say the advance amount is 10% of the total value = Rs. 50,000

This amount is the the premium.

Now at the end of the second month two scenarios can arise because of various factors:
1.) Price of land shoots up (say to Rs. 6 lakhs).
2.) Price drops to Rs. 3 lakhs.

Case I: If case 1 happens, then we will gladly buy the land at the promised rate of Rs. 5 lakhs - we don't need to pay the current market price because the owner promised to give it to us at the old rate of Rs. 5 lakhs.

So now we can buy the land at the old rate and resell it to make a profit of Rs. 50,000.

Profit = Selling price - (premium paid + price of land)
= 6,00,000 - (50,000 + 5,00,000) = Rs. 50, 000

The owner who gave us the option has actually suffered a loss. If he hadn't sold us the option, or if he had charged a higher premium he could have made more money because the land price now has shot up.

Case II: Now if we buy the land then we stand to lose Rs. 2,50,000.
Loss = 3,00,000 - (50,000 + 5,00,000) = Rs. 2,50,000.
Here the owner actually make a good profit while we suffer a loss. But wait; we never promised the owner that we will surely buy the land after 2 months - it was just an option. So now we will decide not to enforce the option in which case we won't buy the land and we will lose the premium we paid for the option - a loss of Rs. 50,000 only. Land owner earns Rs. 50,000 because the land price went down.

So we were the buyer of the option and the land owner was the seller of the option (called the writer). The buyer of the option has limited liability (maximum loss is the premium paid) but the seller has unlimited liability (the higher the land price goes at the end of the second month the greater the loss the seller suffers).
At the end of the second month we had the choice to either enforce the option (called exercising the option - in which case we buy the land at the promised rate) or ignore the option (in which case we lose the premium).

Apply the same concept to stocks and you'll understand what are "options" in terms of stocks. Instead of the land here the underlying asset is the stock of a company. Typically stock options are traded in lots - one lot is usually 100 stocks but it could vary depending on the price of the stock (sometimes a lot is 3000 stocks).

Note: Seller of the option feels the price will go down while the buyer feels the price will go up.

We'll end with a puzzle:

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?

No comments: