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 Introduction to Options:

In our day today life, we have so many OPTIONS to choose a school, college, dress, household items, automobiles, land, home, rental homes etc. In some cases, you pay money (household items, automobiles, land) and choose per your OPTION. In some cases, you pay money (school, college) and if you have the eligibility criteria required by schools/colleges, you choose per your OPTION of selecting a school or college. In some cases, you pay money (option premium) and trade in OPTIONS on stock, index, and currency to avoid risk factor or to make more profits.

Option is a derivative contract which gives the right but not the obligation to buy or sell the underlying on a particular date and agreed price. In India, the underlying may be either stock or index or currency and the OPTIONs works ALMOST in the same ways as expressed below.

Options, may be a bit difficult to understand for some readers at the begining. So, we have explained about OPTIONS with our day to day life examples. Then we will explain how OPTIONS (CALLS AND PUTS) are used in STOCK, INDICES and CURRENCY MARKETS.

Example 1:

You have found a builder who is about to start the construction for several homes in a good place and builder says that the cost of the home is 500,000 (5 lakhs) rupees and he assures that construction will be completed within one year (expiry date). You would like to buy a home for 500,000 (five lakhs) rupees and you are very positive that cost of the home will go up. So, you convey to the builder that you are very much interested in buying that home. You talk to your friends, family and they are confused whether that home price will go up or down in one year. Next day, you approach that builder and tell him that you are quiet confused in buying that home. The builder said 'you are not confident in purchasing this home'; I am giving you an OPTION. There is no need for you to pay the entire amount of 500,000 rupees to buy that home NOW. Since there is a high demand for this home, you can block this home by paying 50,000 rupees as token advance. At the end of the year, if you need this home, you have to pay additional 500,000. So totally, you will be paying 50,000 (token advance) + 500,000 (home value) = 550,000 rupees. if you are not interested, I will NOT RETURN BACK (refundable) that booking advance of 50,000 rupees.

You analyzed about that OPTION, liked that OPTION, and you and the builder sign the agreement and you pay 50,000 rupees. Now you have locked the home price at 500,000 and expiry date as one year by paying that token advance.

Based on the agreement, you are very much convinced that you will not be losing a big amount even if the home prices go down. (Note: At times, home value has dropped to 1/5th of the purchasing amount.) All you have to lose is 50,000/- rupees, which is affordable for you.

Builder is also convinced that you have booked the home and you will be buying it. If you are not buying it at the end of the year, then he gets your 50,000 token advance.

Now, after one year, because of demand, the cost of the home has increased to Seven Hundred Thousand Rupees and you buy that home by paying the amount of 500,000 rupees.

Breakeven Point:
= Home Price + Token Advance
= 500,000 + 50,000
= 550,000

Gross Profit
= Closing Price - Breakeven Point
= 700,000 -550,000
= 150,000

Net Profit
= 150,000 - (other charges incurred by you for your transportation charges, appraiser charges, agreement fee charges etc.)

In the above example, one month is the EXPIRY DATE, and token advance of 50,000 rupees is the option premium. If you are purchasing the home, you will pay 550,000 rupees; if you don't buy it, you will lose your option premium of 50,000 rupees.

Example 2:

A land lord is interested to sell his land. A real estate broker comes to know about that and he approaches the land lord. The land lord informs the broker that he is in desperate need of money, and the land value is 1 crore rupees and the broker will be getting 2% (2 lakhs) as commission, if someone buys the land through his referrals.

The real estate broker appraised (evaluated) the land value and he came to a conclusion that he can sell the land at a higher value of 1 crore and 15 lakhs so that he can get 15% (15 lakhs) profit on the land.

Now, he gives an OPTION to the LAND LORD.

I will give 1 lakh advance to you now and either I will buy the land or someone through me will buy the land within one month and I will pay 1 crore to you at the time of purchase. I may be selling your home at a higher cost also. If either I or someone doesn't buy the land, then there is no need for you to return back that 1 LAKH rupee.

The landlord and the broker sign an agreement.

In the above example, you have the right to buy that home but there is no obligation (mandatory) to buy that home. One month is the EXPIRY DATE, 1 LAKH is the option premium. If the broker is able to sell the land within one month, he gets 15 lakhs as profit; else loses his 1 lakh option premium.

Example 3:

Assume that there are several engineering colleges, which are controlled by a university. Each engineering college can fill their available seats by government quota(recommended students by university) and management quota (college can fill seats by their own). If someone has to get admission in an engineering college, they should get excellent percentage of marks in physics, chemistry and mathematics. Then they have to go for counseling with the university and engineering college will be allocated to them by the university based on the percentage of marks. Then they join in that college. Since more engineering colleges are available, all seats will not be filled by the university. So always there will be vacancies of seats in engineering college (example: A, B).

Since you want to pursue your education in engineering, you are interested in couple of engineering colleges(X AND Y), but all seats ARE FILLED. If some students don't join in colleges X and Y on or before the scheduled date, there is a possibility for you to obtain a seat from X OR Y engineering college. You are not sure whether you will get a set from X OR Y college; So you approach the university, pay some amount to the university and book a seat in Engineering college A. On the scheduled date, you have to pay the full fees and join in the engineering college.

If some vacancies open in X or Y engineering college before your scheduled date of joining in A engineering college by some means you join in X or Y. If there are no vacancies, then you will join in A engineering college.

In the above example, you had the RIGHT to join in A engineering college, but there is no OBLIGATION (mandatory) for you to join in A Engineering College. You paid some amount (OPTION PREMIUM) to the university. If you join in X or Y engineering college, you lose that OPTION PREMIUM.

Option is a derivative contract which gives the right but not the obligation to buy or sell the underlying on a particular date and agreed price.


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