About Option Trading
Call options
A Call option gives the owner the right, but not the obligation to purchase the underlying asset (a futures contract) at the stated strike price on or before the expiration date. They are called Call options because the buyer of the option can “call” away the underlying asset from the seller of the option. In order to have this right or choice the buyer makes a payment to the seller called a premium. This premium is the most the buyer can lose, as the seller can never ask for more money once the option is bought. The buyer then hopes the price of the commodity or futures will move up because that should increase the value of his Call option, allowing him to sell it later for a profit. Let’s look at a couple of examples to help explain how a Call works.
For example, a builder may want the right to purchase a vacant land in the future, but will only want to exercise that right if certain zoning laws are put into place. The builder can buy a call option from the landowner to buy the lot at say 30,00,000rs at any point in the next 3.5 years. definitely, the landowner will not grant such an option for free, the developer needs to contribute a down payment (called premium) to lock in that right. With respect to options, it is the price of options contract. In this example, the premium might be 75,000rs that the builder pays the landowner. Two years have passed, the developer exercises his option and buys the land for 30,00,000rs – even though the market value of that plot has doubled. In an alternative scenario, the zoning approval doesn’t come through until year 4, half year past the expiration of this option. Now the developer must pay market price. In either case, the landowner keeps the 75000rs.
Put options
A Put option gives the owner the right, but not the obligation to sell the underlying asset (a commodity or futures contract) at the stated strike price on or before the expiration date. They are called Put options because the owner of the option can “put” the underlying asset to the seller of the option. In other words the owner of the Put option can sell the underlying asset to the seller of the option at the strike price. Like with a Call option the buyer must pay a premium to have this privilege and this premium is the most the buyer is liable for and the most they could lose. As a buyer of Put options we hope the commodity falls in price because this will increase the value of the Put option, allowing us to sell the option later for a higher price than we paid for it. Try not to let the fact that we want the price of the commodity to go down, in order to make money, confuse you. The main principle “buy low, sell high” still applies, we still want to buy the Put option for a lower price than what we sell it for later. The only difference is that in order for a Put option to increase in price we need the commodity it is based on to fall in price.
For Example. Our land developer owns a large portfolio of blue chip stocks and is worried that there might be a recession within the next two years. He wants to be sure that if a bear market hits, his portfolio won’t lose more than 10% of its value. If the S&P 500 is currently trading at 2500, he can purchase a put option giving him the right to sell the index at 2250 at any point in the next two years. If in six months time the market crashes by 20%, 500 points in his portfolio, he has made 250 points by being able to sell the index at 2250 when it is trading at 2000 – a combined loss of just 10%. In fact, even if the market drops to zero, he will still only lose 10% given his put option. Again, purchasing the option will carry a cost (its premium) and if the market doesn’t drop during that period the premium is lost
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