Each one of you must have sometimes heard the term ‘insurance’ in your life from your parents, friends, teachers, relatives and most importantly family doctors who usually advise you to take health insurance. Even if you have not heard, there is nothing to be worried off, or go up and look in the dictionary, after reading this page you will get to know what is insurance and how it is related closely to the term Options in Stock Market.
Insurance basically is a security for your health, life, diseases, accident and can be of very general things like, theft security, fire security etc. It is important so that during an unfortunate happening like a death or an accident, you don’t need to worry about the finances you require for your treatment or supporting your kith and kin and your savings will not be encroached. In order to get an insurance, what do you pay the company? It is the premium that you pay every year, quarter or monthly as per your choice and financial stability. And the company will issue you the policy with the benefits.
Now, you must be wondering, am I here to talk about the Options or Insurance Policies? But, this background was required to establish a close relation between Options and Insurances. Up till now, how the insurance works for an individual who is buying the policy from a company. This is similar to buying an option in the stock market. Now, let us see how this is profitable for the company who is selling the policy. Basically, the company issues policy to a wide range of customers and collects premium from them every year. It reinvests the amount collected in the Equity Markets for a better return of investment. And it is hardly 0.1% of the total customers who claim the amount from the insurance company at dreadful times. So, in this way the company runs profitably. This is similar to selling an option in the stock market.
So, Options are securities which you Buy/Sell in the stock market and pay/collect premium from the opposite party so that when the maturity of the option is arrived, either the buyer of the option gets a chance to claim from the seller or the seller wins the premium if the claim is not successful.
There are two types of options which are traded by the NSE (National Stock Exchange) in the market. They are -:
- Call European (CE)
- Put European (PE)
Let us see them in detail-
Call European (CE): Call Option means the buyer has the right to buy with no obligation to sell and the seller of the call option has and obligation to sell. Before going into the details, we first need to understand some basic terms related to options.
Basic Terms:
- Strike Price : This is the price which is close and comparable to the actual spot price of the stock.
- Expiry Month : It is the date of expiry of the option similar to the maturity date of an insurance policy. It means you can buy/sell this option before this expiry ends and after that you can exercise the claim of this option if the condition arises. For stock options, they expire on the last Thursday of every month unless there is a national/gazette holiday.
- Premium Per unit : It is the amount of premium that you have to pay at the time of buying the option or you get at the time of selling an option.
Let us see an example of what does exercising an option claim means –
The current market price of Reliance Industries Ltd is Rs. 1937/ share. If an individual buys a Call option of Reliance 2000 strike price of May month expiry at a price of Rs. 17.80 per unit. Generally, options and futures are traded in lots of fixed sizes. So, for Reliance Industries, you have to buy a minimum of 250 units if you trade in futures or options.
When you buy a call option of 2000 strike price, it means that you are having a bullish view for the stock and believe that the stock price will cross Rs. 2000 mark at the end of May month expiry. So, there can be three scenarios,
- If the price is below 2000 at the end of expiry à In this case, the value of the 2000 CE option will go down to Rs. 0.00 and whatever premium the buyer has given at the time of buying the option has matured without receiving any claim from the seller because the condition is not fulfilled and the buyer will be at loss and the seller has win the total premium.
- If the price is above 2000 but below 2017.80 à In this case, the value of the option will be equal to the difference between the price of the stock at the end of expiry and 2000. Again here, the buyer will be at some loss and seller will be at some profit.
- If the price is above 2017.80 à In this case, the value of the option will be equal to the difference between the price of the stock at the end of expiry and 2000. Now this time, the buyer will be in profit and the seller will be in loss. Here, the buyer can either exercise the option by claiming the right to buy the shares of Reliance Ltd. at the price of Rs. 2000/share (minimum 250 qty needs to be bought) even though the current market price is more than 2017.80 and the seller will have an obligation to sell the stock at Rs. 2000/share or the buyer/seller can close their option trades without going into physical deliveries of stocks.
Summarizing in a table,
Put European (PE): Put Option means the buyer has the right to sell with no obligation to buy and the seller of the call option has an obligation to buy. Let us take the same example of Reliance Industries with a put option this time.
If an individual buys a PUT option of Reliance 1900 strike price of May month expiry at a price of Rs. 21.10 per unit, it means that he/she is having a bearish view for the stock and believe that the stock price will go down below 1900 mark at the end of May month expiry. So, there can be three scenarios again,
- If the price is above 1900 at the end of expiry à In this case, the value of the 1900 PE option will go down to Rs. 0.00 and whatever premium the buyer has given at the time of buying the option will be matured without receiving any claim from the seller because the condition is not fulfilled and the buyer will be at loss and the seller has win the total premium.
- If the price is below 1900 but above 1879.90 à In this case, the value of the option will be equal to the difference between 1900 and the price of the stock at the end of expiry. Again here, the buyer will be at some loss and seller will be at some profit.
- If the price is below 1879.90 à In this case, the value of the option will be equal to the difference between 1900 and the price of the stock at the end of expiry. Now this time, the buyer will be in profit and the seller will be in loss. Here, the buyer can either exercise the option by claiming the right to sell the shares of Reliance Ltd. at the price of Rs. 1900/share (minimum 250 qty needs to be sold) even though the current market price is less than 1879.90 and the seller will have an obligation to sell the stock at Rs. 1900/share or the buyer/seller can close their option trades without going into physical deliveries of stocks.
Summarizing,
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