Put simply, an option is a contract. An agreement giving buyer the right to buy (‘call’) or sell (‘put’) an asset at a given price before an agreed-upon date. Remember it is not an obligation, just a right. If you don’t feel like buying or selling that security till that cut-off date, you can let that go. However, you’d have to pay a premium to buy this right.
Let me illustrate this.
Consider that you are in the market for a house. You finally found the prefect one in Bellandur and heard that Modi Sarkar would soon build a metro station near it. Manju, the house owner, wants 2 cr for his flat. You don’t have this much money now, but you will soon.
Sensing the potential, you don’t want Manju to approach other buyers or to put it on Magicbricks. So, you offer him a deal, “take these 2 lakhs now as token and I’ll pay you the 2 crs before 31st March”. Manju agrees.
Hurrah! You just purchased a call option.
Strike price = 2 cr
Premium = 2 lakhs
Expiration = 31st March
Now, any of the below two scenarios might play out.
1. Sarkar builds metro and prices rise to 3 cr
2. Sarkar says abhi ruko jara and prices drop to 1 cr
In scenario 1, you’ll exercise your right and pay Manju only 2 cr for the property that’s worth 3 cr, amassing a massive profit of 2 cr – 2 lakhs = 98 lakhs.
In scenario 2, you’ll just switch off your phone and won’t buy that house. You incurred a loss of 2 lakhs, but you knew the risks. Hota hai, Simran.
Effectively a small sum gave you the control of that asset. These were call options.
There are ‘put’ options for bears as well that give them the right to sell an asset before the cut-off date, but more on that later. If you are wondering why aren’t we talking about futures and margin trading? Hold your horses, Rihanna. We will cover them next.
Have a good night!