Exploring Stock

Finance Options
for
Common
Person
Finance for common man is a series of articles on various finance
topics, which will be useful to people who does not have finance
background .

This article is on Options (so called financial derivatives or Options and

Future). We will explore about Options, a derivative instrument, in
Volume- I,
this article. I have tried my best to make this document simple so that Series- 2
anyone, not necessarily a Wiz in finance, can understand. I have not
used any graphs or much of technical terms. If you have any
feedback/suggestions/criticism, please let me know @
rameshbaboov@gmail.com

Please feel free to share this with anyone who might be interested, but only for personal use and
without any modifications. Please provide your feedback/suggestions to rameshbaboov@gmail.com
 MINNANJAL – Vol -1- Finance for Common Man Series -2

Contents
1 Option Price/Value..............................................................................................................................3
2 Option specification.............................................................................................................................4
3 Possible actions with Options..............................................................................................................4
4 Options in practice - Speculation.........................................................................................................5
5 What is Hedging...................................................................................................................................5
6 Hedging using Options.........................................................................................................................6
7 In the next series.................................................................................................................................7
 MINNANJAL – Vol -1- Finance for Common Man Series -2

1 Option Price/Value

What is the option price? It is nothing but the premium that you need to pay to get the option. You buy
an option at an expected price called Strike price. This is the price above or below which you expect the
underlying stock to move in future. So if you buy a call option for 500 USD/INR, then you expect the
price of the underlying stock to exceed 500, in future. Similarly, if you buy a put option for 300 USD/INR,
then you expect that the price of the underlying stock will go below 300 in future.

The price of option depends on two factors.

 The duration by which option will expire from the given day
 How near is the price of the underlying stock compared to the strike price?

Say for example, if an option is for 500 USD/INR and current price of the stock is 10 USD/INR, then
nobody will be interested in buying the option. Naturally you can expect the price of the first option to
be higher than the latter.

Let’s see how. If you buy a call option for 500 INR/USD and the price of the underlying stock increases to
550, then at the time of exercising the option, you buy the underlying stock for 500 and not for 550. So
you gain an amount of 50 INR/USD and this price differential increases the value of the option. You can
sell the stock for 550 and earn an arbitrage amount of 50 INR/USD

Similarly, if you buy a put option for 300 INR/USD and the price of the underlying stock decreases to 200
INR/USD, then you can buy the stock in market for 200 INR/USD and then sell the stock in option for 100
INR/USD. Remember you do not need to hold the stock at the time of entering into the option.

Also, if there is an option that expires in next two months and another option that expires in one month
and assuming that the strike price of both options are near to the underlying stock’s price, then it can be
understood that the latter will be more costly compared to former. There is much uncertainty on what
could happen in next 2 months compared to uncertainty of the latter.
 MINNANJAL – Vol -1- Finance for Common Man Series -2

2 Option specification

Any Stock option has few characteristics or specifications that we need to be clear about

1. Option Price of the Premium of the option

2. Strike price of the option
3. Option type – Whether put or Call
4. Underlying Stock
5. Exercise Date – Date on which option expires
6. Option type – American/European. This will not be explicitly specified in any option listing

3 Possible actions with Options

There are few possible things that you can do with option

1. You can buy an option – either Call or put option and this is called going long on option
2. You can sell an option – either call or Put option. This is called going short on option
3. You can exercise an option – i.e. take delivery of the underlying stock. For ex – if you are long on
a call option, buy the stock or long on sell option – sell the stock
4. You can square off an option – i.e. you take a reverse position in option. For example, if you
have bought an option, then take reverse position by selling the option. For understanding
purpose you can assume that this is similar to buying a stock and later selling it. So you don’t
have any option left with you. But you either gain or loss when you take a reverse position.
5. You can let the option expire without exercising. In this case, you lose your money that you paid
as premium.
 MINNANJAL – Vol -1- Finance for Common Man Series -2

4 Options in practice - Speculation

Now let’s see how someone makes money using speculation. Speculation is nothing but taking
advantage of any price change by buying/ selling or short-selling of a stock. For example, if you expect
that price of a certain commodity will increase in a span of time, you buy the item and then sell it later,
it is a speculation.

Similarly, if you expect price of a stock to increase in future, you buy the option and later take a reverse
position in it. Your amount of investment is very less as you do not need to pay price against the entire
stock value, but only premium.

If the price doesn’t increase as you expected, then you don’t run into heavy losses, as the case would
have been, had you invested in stock. You can simply let the option expire and hence you know that the
maximum loss that you will incur.

But as a speculator, you will never take delivery of the stock because you are not intending to buy or sell
any stock.

5 What is Hedging

Assume that you are running a small business and exporting to a foreign country. You will be spending in
your local currency but receiving the revenue or money for your exports in foreign currency. It is obvious
that you don’t receive the foreign currency immediately when your product is ready or on the day when
it is exported. You usually have to wait for a time till you receive the payment. However, in the mean
time, if the exchange ratio changes and foreign currency strengthens, though you may be receiving the
committed amount in foreign currency, you lose some money when you convert it into local currency.

This reduces your profitability. Your spending/cost has not come down, but your income has come
down. You do not have any control over this phenomena is a macroeconomic factor. How can you
ensure that you don’t run into loses for such reasons?

The answer is that if you can fix the exchange rate then you don’t lose. But you can’t do that. So what is
the alternative?

Say assume that you enter into a contract with someone to sell the foreign currency (that you will
receive) in a future date at a fixed price. Then irrespective of whatever the currency exchange rate
fluctuation, you can sell the foreign currency and receive the expected money. You are eliminating any
risk that can occur because of change in exchange rate. This is nothing but hedging.
 MINNANJAL – Vol -1- Finance for Common Man Series -2

However, the negative part is that if the foreign currency depreciates, then you enter into a loss (though
not really a loss, but only an opportunity loss). This is similar to hedging using futures or forward
contracts.

Similarly if you own say a huge volume of shares and planning to sell it at a later stage, you again run
into risk of losing value if the shares price decrease in future. So you need to hedge your stock against
any price fluctuating.

So you can understand that in hedging, the objective is not to maximize the profit, but to ensure that
you are prevented from risk of price fluctuations.

6 Hedging using Options

In both the examples, say if you enter into a long contract for a put option on the same underlying stock
as the stock you hold, then you are hedging. Let’s see how. If the price of the stock that you own
decrease, then you know that value and price of put option increases.

The Loss in share value, that you incur when the price decreases, can be recovered through the price
appreciation that happens in the option. However, if the stock increases in value, then you can let the
option expire without any action and the premium that you paid can be forgone and written off against
the price appreciation that you get from the stock.

This is better than the hedging strategy that we saw using futures.

This situation is similar to the one where you take insurance for your car and if there are any damages
you can claim the insurance to the extent of damages and if you are fortunate and nothing happens to
your car, then you forgo the insurance paid. Thanks to the fact that options does not remember your
claims and increases your premium unlike car insurance.
7 In the next series

• What is long/short/call/put and trick of remembering?

• Why is short on option is risky?
• Underlying securities in options
• Option - who makes money and who lose?
• Options in Indian Stock market
• Option Strategies and risks involved
• Is Options a Gambling?
• Why should someone get involved in short position?

Please feel free to share this with anyone who might be interested, but only for personal use and
without any modifications. Please provide your feedback/suggestions to rameshbaboov@gmail.com
 MINNANJAL – Vol -1- Finance for Common Man Series -2

Please feel free to share this with anyone who might be interested, but only for personal use and
without any modifications. Please provide your feedback/suggestions to rameshbaboov@gmail.com