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Basics of Options

A. Option

Is a

- Contract

- That gives the buyer a right but not the obligation to buy or sell
- That gives the buyer a right but not the obligation to buy or sell a security or other financial
- at an agreed upon price ( called strike price or exercise price )
- during a certain period of time, including maturity date ( American options ) OR which can be
exercised at maturity date only ( European options )
Two types
1. Put option ( option to sell )
2. Call option ( option to buy )
Option premium
Is the amount paid for a call or put option
Numerical Example number 1 ( call option )
Superman buys a call option ( at premium of Rs. 5 ) from Batman for certain share valued at Rs. 100 at
the moment. Both agree an exercise / strike price of Rs. 125. This gives right to Superman to buy the
shares at Rs. 125 at the exercise date ( let’s say 2 months from today )
Possibility number 1
Share price rises to Rs. 150 before exercise date. Superman will buy share from Batman at Rs. 125 and
sell the share in market at Rs. 150.
This will result in net gain of Rs. ( Receipts from sale – payment for purchase – premium paid for option )
That is = 150 - 125 - 5 = Rs. 20
Possibility number 2
Share price is below Rs. 125. Superman will let the option lapse

This will result in a loss of Rs. 5 ( the premium )

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Numerical Example number 2 ( put option )

Superman buys a put option from Batman to sell the shares at Rs. 100 at an agreed date.

Possibility number 1

The price of share falls to Rs. 75 . Superman can buy share from market at Rs. 75 and sell them to Batman at Rs. 100. (Ignoring premium in the example) this will result in net gain of Rs. 25 ( Receipts payments ) ( 100 75 )

gain of Rs. 25 ( Receipts – payments ) ( 100 – 75 ) Possibility number

Possibility number 2

The price rises to Rs. 150. Superman will not exercise the option and let it lapse since if he owns any shares they can be sold in market at Rs. 150 which is higher than what Batman will offer that is Rs. 100.

Numerical Example number 3 ( hedge )

Superman owns a share valued at Rs. 100. Due to uncertain market conditions Superman knows that the share prices may move either way ( that is they may increase significantly or decrease significantly ). He also knows that he cannot bear a loss of more than Rs. 25 if prices fall significantly . He can buy a put option to sell the shares at Rs. 75 ( ignoring premium in this example for simplicity ) so if the share price falls below Rs. 75 , let’s say Rs. 50 or even Rs. 40 . He can exercise the option which will result in maximum loss of Rs. 25.

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