OPTIONS

Options

Forwards and futures can be used to hedge against adverse movements in asset prices. This is the major advantage of these financial instruments. However, these derivatives do not give chance to get the benefits that may accrue due to favourable movements in asset prices. The reason for this is that the firm is under obligation to buy or sell assets at predetermined rates. This limitation of forwards and futures has led to the emergence of options.

Meaning of Options

The word option simply refers to choice or freedom. This choice or freedom may or may not be used depending upon the situation. Option means right without obligation. An option is a contract that gives the holder (owner) the right, but not the obligation, to buy or sell an underlying asset at a specified price on or within a specified date in future.

Thus, option is a special type of contract which gives its holder the right, but not the obligation, to buy or sell an asset at a fixed price at some future date) For example, one person buys an option contract to purchase 100 shares of SBI at 250 per share within a period of 3 months. It means that the said person has the right to purchase the shares of SBT at 250 per share within 3 months from the date of the contract. If the share price increases, he will exercise the option. This is because he can buy shares at 250 even though the price is increased. If the share price falls below 250, then he will not exercise the option (he has no obligation to buy). This is because he has to pay 250 for one share even though the market price is fallen. Thus, it is clear that an option is the right but not the obligation to buy or sell something at specified date at a stated price. It means that the option buyer will exercise the option when he is in profit. In case of loss, he will not exercise the option.

Features of Options

The important features of options are as follows:

• It is a contractual agreement that gives the buyer the right, but not the obligation, to buy or sell a specified asset at a specified price on or within a specified period.
• There are two parties to an option contract. One is buyer (investor or owner) who buys the right. Second is writer (seller) who sells the right (to buy or sell) to the buyer.
• The seller of option sells the right to choose to the buyer in return for a payment called premium. Hence option is somewhat similar to insurance.
• The buyer of option may exercise his right or may not exercise his right) He will exercise his right only when it is beneficial for him by doing so. He shall not exercise the option. He shall let the option expired. Then he will lose the premium paid. It becomes a gain to the seller.
• The seller has no choice. He has no right. He has only obligation. This means that he must meet his obligation when the buyer exercises his right.
• There are two types of option-call option and put option.
• The buyer of option should exercise his right at any time during the period of contract, i.e., at any time between the signing of the contract and the expiry date (American style). This intervening period is called expiration period. If the buyer does not exercise the option within the specified period, the option gets expired.
• The specified or agreed price at which the owner is allowed to buy/sell the specified asset is called exercise or strike price. It is the price at which the option (right) is exercised.