In options trading, there is a contract between a buyer and a seller of a particular asset for a specific period. This contract gives the buyer the right but not the obligation to buy or sell a particular asset at a fixed price for a specific period but it obligates the seller to meet the terms of delivery if the contract’s rights are exercised by the buyer.
The above definition can be further elaborated with the help of an example, suppose there is a buyer who wants to buy a house which costs approximately Rs. 30 lakhs. He likes the house as well as its price but he needs time to think about and enquire other options also before buying this one. However, he also fears the house’s price going up in the meantime. So he contacts the seller of the house and asks her if she can make an options agreement with certain terms and conditions.
The options agreement could be like, the seller will hold the house for three months and in the meantime, no one will be allowed to buy it. It also means that no matter how high the price may rise the buyer will be allowed to buy it for Rs. 30 lakhs within the duration of these three months. Even if the price rises to Rs. 40 lakhs the buyer will still be allowed to buy it for Rs. 30 lakhs but what if the price goes down to Rs. 20 lakhs, still as per the contract there will be no obligation for the buyer and he can walk away from the deal.
But how will the seller profit from this deal?
For holding the house for three months, the seller will get a compensation amount, a small percentage of the purchasing price of the house. Let us take it 1 per cent, which means 1 per cent of purchasing price Rs. 30 lakhs will be Rs. 30,000 and this is called a premium. With this premium of Rs. 30,000 she will hold the house for three months and the buyer need not pay more than Rs. 30 lakhs within the time period of three months to buy the house. Only a small premium of 1 per cent will be payable for now. If the buyer changes his mind, he would only lose this premium amount paid to the seller.
So what are the possibilities of the transaction?
- If the value of the house rises to Rs. 40 lakhs buyer can decide to buy it for Rs. 30 lakhs as previously agreed by making Rs. 10 lakhs profit and this is called exercising of options agreement by the buyer. There’s one more possibility if the price of the house rises buyer can sell the rights of the contract to another buyer. This will be explained further in future posts.
- If the buyer changes his mind or price of the house drops to Rs. 20 lakhs he is not obligated to buy it at the loss of Rs. 10 lakhs, instead he can walk away with Rs. 30,000 premium loss.
- On the seller’s side, she is receiving a premium of Rs. 30,000 and if the buyer doesn’t want to buy the house after three months she can write another agreement with another buyer.
Let us take another example with the help of an asset – stocks
Suppose there is a buyer who wants to buy the shares of “XYZ” company which is trading at Rs. 100 per share. He believes that the price of the stock will rise in future, so instead of directly buying the shares, he decides to buy its options contract.
Now according to the options contract, the buyer has the right to buy 1000 shares of “XYZ” company for Rs. 100 per share at a premium of Rs. 5 for one month. If the stock price rises to Rs. 105 per share, he can exercise his contract and buy shares of “XYZ” company for Rs. 100 each.
But what if the price of the stock goes down to Rs. 95 per share? This might not interest the buyer anymore and he can let the contract expire worthlessly and move away with the loss of only premium amount.
The seller will receive the premium of Rs. 5 per share which means for Rs. 5000 (Rs. 5 premium * 1000 shares = Rs. 5000) buyer has the right to buy 1000 shares of “XYZ” company for Rs. 100 per share for a month. Now If the buyer had bought the shares of the company instead of options contract it would cost him Rs. 1 lakh which is a lot more than Rs. 5000.
There is one more scenario for the buyer if the stock of “XYZ” company rises from Rs. 100 to 105 per share its premium will also rise, let us take from Rs. 5 to Rs. 15 which means the value of the premium rises from Rs. 5000 to Rs. 15,000. Now the buyer can sell the rights of this contract to another buyer who is willing to buy this contract at Rs. 15,000 and makes a good profit.