Understanding Options — Basics

Hello everyone, In this series of article, we are going to talk about Options, a type of derivative. Well, I will try to keep it as simple as possible and then slowly build up all the complexity on top of it.

If you are even remotely familiar with financial instruments, you must have heard of Options, people throw it around with so much confidence. But before getting to Options, let me tell you about a term named as derivative.

If you google the term Derivative : something which is based on another source

And yes, even in Finance, it is right on spot. A derivative is product (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset, such as a commodity, currency, or security.

Eg.1 — Let’s take an example by playing a game of bet. Two gamblers A and B each place $100 over a coin toss, if it’s head, A pockets $200 and if it’s tail B keeps $200. Sounds pretty simple, right?

Let’s suit up and make it more formal as we are professionals.

Eg.2 — A farmer and a Banker bet on the price of wheat to be harvested 3 months from now. They agree to lock the price at $2000/Ton. They chose $2000 as the Market price of wheat at the time for 100 Tons of wheat.

Now if at the time of the harvest, the market price stays at $1700, the banker loses $300/Ton and the Farmer gains $300/Ton as profit. And the situation would be opposite in case the market price of wheat at the time of harvest is above $2000.

As we can see that the contract is more or less Risk Neutral given no parties has any inside information. Now let’s see what are the parameters that needs to be defined before entering into a futures contract.

1. Underlying Instrument : Wheat
2. Expiry Date : 3 months
3. Contract size : 100 Tons

Seems pretty simple right? Yes, this is the futures contract and the above parameters (Underlying, Expiry , Contract Size) are fixed by the Exchange and the buyers and sellers just need to pick and enter contract by pressing couple of buttons on their terminal.

Now on electronic terminal, there is no way to ensure if the farmer actually has 100 Tons of wheat in his field to harvest and hence Margin amount is blocked to ensure that no party defaults. Exchange needs brokers to ensure that the participating party has sufficient amount in their DEMAT account.

Let’s remove the physical wheat from the picture and just take the price of the wheat from the market and make the contract between two parties. Nothing changed !!! And the contract is perfectly valid. Here we can also remove the Farmer and Banker from the picture and bring in just two random people with varying viewpoints. The contract is still the same. This is what a futures contract essentially means.

One more thing, there is no value creation here in the complete overall transaction. If we look analytically at the complete setup, in both of the above examples, the person who lost has transferred the difference to the person who won and hence there is no money created or destroyed. Derivative is a zero-sum game.

I really want to put emphasis on the above statement to make this clear that everyone cannot win at the game of derivative. For a party to win, the counterparty must lose. And this makes is far more competitive than any other business.

Let’s proceed to example 3.

I run an Insurance firm for 2 wheelers for accudent protection. Taking in all the data of the passenger and his vehicle, I price the insurance amount to be $200 for an year. In turn I assure that in case of accidental damage, I’ll be covering the cost of the damage.

Let’s understand why the price for the Insurance is $200. According to the survey data, the average cost for a damaged 2 wheeler is $1500. And the rate of accident is 5% in a year. One in 20 vehicle will face a damage in a year. Without getting into maths, we can see that placing a fare charge for the insurance is where both the parties, the insurance seller and the buyer comes under a risk neutrality.

This risk neutrality is governed by free markets, if the insurance company steeps up the price for the insurance, more and more people will start selling the insurance cheaply and the company will lose customers. If the company discounts the price too much, it may suffer loss as the premium collected may not cover for the damage claims made. Let’s dissect the example so that we may be able to make the contract unit and take it to exchange.

Underlying : 2-Wheeler’s condition

Time to expiry : 1 year

Insurance buyer’s premium : $200

Insurance seller payout : $1500

If we compare the Example 2 and Example 3, we have some stark difference. The Probabilities of the events have changed.

If the price of wheat is $2000/Ton today, at any point in future, it can be 2000+x or 2000-x with equal probability. But the probability of a vehicle making an insurance claim is 5%. Now let’s try to migrate this example to the farmer and banker.

But if the price of wheat is $2000/Ton today, rather than farmer and banker betting on 2000, they speculate on $3000/Ton. Again the amount of bet will also change for both the banker and the farmer. So here’s the modified contract.

A call option contract, expiring in 3 months, set a $3000/ton price for wheat. Farmer paid banker a $200 premium.

As the name defines, an option contract is option for buyer to exercise, whereas obligation for seller to comply. As we have done earlier, we can remove the stationary elements and take the contract to the exchange.

So, here are the things that is already defined by the exchange —

1. Underlying Instruments
2. Time to expiry
3. Lot size
4. Strike Price
5. Option Type

Here, we have Strike Price, essentially stating where do we want to place our bet and option type, which states that which direction is the option buyer betting for the price to go and is denoted by Call or Put. The buyer can have the option to go Long(wants the price to go up — Call) or go Short(wants the price to go short — Put)

That was a lot of Imagination. Let’s take some actual contract and dissect it out.

Instrument 1 : NIFTY FEB 22000 CE

The format for the option stays the same

Underlying | Expiry | Strike | Option Type

The lot size is not mentioned in the Instrument Name and is declared in instrument book, led out by the exchange and can also be obtained by the broker.

Here the lot size for both of the instrument is 50, and the underlying i.e. Nifty is at 21853. Now what does it mean to enter into contract.

If I place a Buy order for NIFTY FEB 22000 CE which is currently trading at 300 INR, it means that by paying 300, I lock in the price of Nifty Futures at the Strike Price at the time of Expiry which is 1 month from the date of writing.

So, I have purchased this contract. When do I profit? So the premium is being pocketed by the seller of the option. As you can see, to profit out of this agreement, the price of the underlying at the time of expiry need to cross (Strike + Premium) which is 22000 + 300.

Say the Price of the Underlying at expiry is 22500, Profit will be —

22500 (-) 22000 (-) 300 = 200

I really need you to understand the above piece of information very clearly, if you are new to this whole options thing, this might take you a while to digest, but it’ll be a piece of cake once you grasp the concepts intuitively.

Let’s calculate the Breakeven point for the Instrument 2, which is a Put Option

Breakeven for NIFTY FEB 22000 PE =

22000 (-) 344 = 21656

So if we enter into the Put contract, we would like to see the price of the underlying going below 21656 by the expiry date, Or else we are going to incur a loss. And as we have already discussed the derivative is a 0 sum game, whatever is the loss we incur, is being kept by the seller. A small part of the trade is kept by the facilitator (i.e. exchange and broker)

Now the returns, we get from entering into the contract at the expiry varies with the Underlying value. So we can calculate our expected PnL at various values of Underlying. This Table of Underlying vs PnL is what we call Payoff

We will be diving deep into the world of Payoff in the upcoming series of the options, for now I really would like reader to take as many examples as possible and check the breakeven points.

One Question to Ponder is the Incentive of the option seller? We will be discussing such questions in the later series as well. See you in the next part. Happy learning !!!

So let’s see how much you’ve retained from the blog

QuizShorts | Understanding Options - Basics

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