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personal finance

Put, call and all that are options

A previous classroom introduced a few concepts of equity derivatives trading. In this edition, ET gives the lowdown on equity options

1. What are equity options?

They are instruments that derive value from underlying indices like Nifty and Bank Nifty, etc, and permitted stocks traded on the exchange. They are of two types — call and put options. You can trade a call on a stock or index.

2. What are call and put options?

A call gives a buyer the right to buy an underlying stock at a fixed price on a certain date by paying a premium which is a fraction of the underlier’s cost . A put similarly gives a buyer the right to sell the underlier. A seller of a call receives a premium from a buyer and is obliged to deliver the underlier at the contracted price to the buyer. A put seller, similarly, has to sell the underlier . In practice only the difference is exchanged , except for certain stocks where physical delivery is mandatory.

3. How does this really work?

Assume that on December 21, a trader buys a 10,800 call on Nifty expiring on December 27 for Rs 62 a share (75 shares make one contract) . On December 27 Nifty ends at say 10,900. The 10,800 call is Rs 100 ‘in the money’. So the call seller pays the trader Rs 100, which is a gain of Rs 38 gain on the Rs 62 per share the trader paid. This of course excludes taxes and brokerage. But it’s a 61 per cent gross return on investment. Now assume Nifty closes at 10,700 instead. The 10,800 call ends Rs 100 ‘out of the money’ and the call buyer loses the entire premium (Rs 62) to the seller. The same illustration works in case of a put option except that the buyer gains if the Nifty falls and the seller gets to keep the premium in case Nifty rises or remains flat.

4. How is it different from futures?

In the above instance, the buyer’s loss is limited to premium paid but the call and put seller could face unlimited losses . Profits for the call and put buyer can be theoretically unlimited. In the case of futures , profits and losses for buyers or sellers can be unlimited .

5. What are the types of options?

There are two types: American and European. In the American style, options can be exercised any time during the tenure of the contract while European options can be exercised only at maturity of the contract. India follows European style, where contract are usually squared off rather than exercised before maturity.


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