The wisdom of the wise says that derivatives are financial weapons of mass destruction, which pass the risk to the dumbest guy in the room. Undeterred by such warnings, our friend Johnny is interested in designing derivative products of his own. But, there is a problem—Johnny has no idea of how derivatives work. Last week, Jinny explained to him how futures contracts help in hedging price uncertainties. Their discussion is still not over. Let’s join in their ongoing discussion on derivatives:
Johnny: Jinny, tell me about options before I start getting confused.
Jinny: Options, as the term suggests, are a special kind of derivative instrument in which a purchaser has the option, but not the obligation, of buying or selling the underlying asset or instrument at a predetermined price, which is also called the strike price. Options are of two types: put options and call options. Put options give you the right, but no obligation to sell. Likewise, call options give you the right, but no obligation to purchase. You can also classify options on the basis of their underlying assets or instruments. For instance, if the underlying of an option contract is a stock index such as the Sensex or NSE Nifty, then it is called an index option, and if the underlying asset is individual equity shares, then it is called a stock option. All these options, with simple straightforward features such as right to put or call at a strike price, are also called “plain vanilla” options. You could also have options of a more “exotic” kind with tailor-made features that are mostly traded privately over the counter (OTC). For instance, in one type of option called a “chooser option”, or “preference option”, the purchaser is provided an opportunity to choose whether the option is for put or call during the period of the option. In fact, there are so many exotic options that even a lengthy book may not be able to fully describe them.
Johnny: So much about options of different flavours. What about European and American options? Do we have options for different geographical boundaries, too?
Jinny: Well, European or American options have nothing to do with geographical boundaries. Their main difference lies in the time frame during which the option has to be exercised. A European option can be exercised only at the expiry date or the settlement date, whereas an American option can be exercised at any time before the expiry date. Much can happen between the day you purchase the option and the day you exercise it. So, American options give you better flexibility in exercising your rights.
Johnny: That’s great! Options give you the right but no obligation. No risk, all gains. Tell me, how is this possible?
Jinny: This is possible because somebody else is there to take your risk. But, nothing comes for free. The purchaser of the option has to pay the seller a premium to acquire the right to buy or sell the underlying instrument or asset at the strike price. The seller of the option undertakes the corresponding obligation to sell or buy. The purchaser of an option can always compel the seller to fulfil his obligation, whereas the purchaser himself is totally free of any obligation. At the settlement date, the purchaser can either exercise his option, or let it simply expire. He is not going to lose anything more than the premium, which he has already paid to the seller of options. You might have noticed that the purchaser of an option pays a fixed price but enjoys the possibility of unlimited gains, whereas the seller receives fixed profit but runs the risk of unlimited loss.
Johnny: What? The situation seems really complicated.
Jinny: OK! Let’s try to understand how this works by taking an example. Suppose, I purchase a call option for a stock from you to be exercised at the strike price of Rs100. I pay you Rs10 as a premium for purchasing the option. Now, take a look at our respective positions. At the settlement date, I have a right to purchase the underlying stock at the price of Rs100 from you. I can exercise that right or simply let it expire. By common sense, I will exercise my right only if the price of the stock on the settlement date remains higher than the strike price. If the market price is Rs150 on the settlement date, I can purchase the same stock from you for Rs100 by exercising my option. The higher the price, the more my profit. In case the price of the stock falls below the strike price at the settlement date, I simply let the option expire. In that case, my loss is limited to the Rs10 paid as premium. Now, let’s consider your position. In your case, the more the prices rise, the more loss you suffer. But, in case of a fall in price, your profit is limited to whatever premium you have received. This is what makes you feel like the dumbest guy in the room.
Johnny: Thanks, Jinny, for enlightening me. But, I have many more questions about derivatives. We’ll talk about it some other time.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org
What: Options are derivative instruments that provide the right, but not obligation, to buy or sell the underlying at the strike price.
Who: The purchaser of the option acquires the right, but no obligation. The seller of the option (option writer) undertakes the obligation.
When: American options can be exercised on any date before the expiry date whereas European options can be exercised only on the expiry date.
How: Plain vanilla options are traded on the floor of stock exchanges while exotic options are tailor-made by private negotiation.