When I first time i bought the stocks of XYZ Company with a great hope of making a quick profits I did not focus on the other side of the picture i.e. making great loss. The lot size on the contract was 950, which meant that for every single rupee up or down move in the stock I stood to gain or lose Rs. 950, The market took a dip and my stock ended up lower by Rs. 40. In simple words I lost Rs. 38000 in just a couple of weeks. Although I had time till the end of the month when the contract expired but I closed my position taking the loss. Another lower tick on the stock would have required additional margin money from me.
Did it leave me any wiser? I sure hope so because that is when I tried doing some research and came up with a safer bet in the form of stock options.
The difference in buying a stock future and stock option is that the later is not obligatory.
The future is an agreement to buy or sell a security at a certain time in the future at a specified price, an option gives one the right but not the obligation to do the same.
This right to buy or sell in options comes at a price, which is called the premium.
Types of option: There are two types of options –call option and put option. A call option gives the buyer the right to buy a security on a future date at a predetermined price; Put option gives him the right to sell a security on a certain day at a certain price. The future price is called the strike price.
Benefits of Stock Options
• gives the buyer the right
• Not the obligation
• To buy or sell
• A specified underlying
• At a set price
• On or before a specified date
Now let us see how it works out :
The stock of xyz is trading at Rs. 90 and you expect it to go up to 110
In cash segment you buy 100 shares and pay Rs. 9000, (100 shares x Rs. 90)
If the stock reaches your target of 110 you make Rs 11000 by selling your 100 shares at Rs. 110/share
If the stock falls by Rs. 50 you make a loss of Rs. 5000 by selling your 100 shares at Rs. 70/share
In futures you buy a contract of 500 shares (lot size) of the same share for Rs. 45,000 (500 shares x Rs. 90)
If the price reaches 110 you make a profit of 35000 (500 shares x Rs. 70)
If the price falls to Rs. 50 you make a loss of 25000
In options you buy a call option (right to buy a security) for 500 shares at a strike price of Rs. 105 paying a premium of Rs. 2500 (assuming a premium of Rs. 5 per share for 500 shares)
If the price reaches 150 a profit of Rs. 45 per share (Rs. 150-Rs. 105) the net profit after deducting the premium of Rs. 5 per share paid by you gives you a profit of Rs. 40 per share or a total amount of Rs. 20000 ( 500 shares x Rs. 40)
The option shows its advantage if the price drops by Rs. 50. You have only bought the right to exercise an option to buy. Therefore if for some adverse reason the stock price plummets your loss is limited to the amount of premium you have paid in this case Rs. 2500 ( the premium paid by you for the right to buy 500 shares at Rs. 105)
As is clear from the example, options have a clear advantage in limiting your risk.
Buying a call option is a bullish stance where you expect the price of stock to rise and buying a put option is a bearish stance and you expect the price of stock to fall.
Selling options can be as risky as futures. The seller or writer of an option takes a huge risk in case of unfavorable price movements. He only profits from the premium he collects from the option buyer for providing assurance to buy or sell securities at a pre determined price.