INVESTMENT FOR BEGINNERS – UNDERSTANDING OPTIONS

When a person decides to invest in the financial markets, there is a plethora of options available. One can choose to invest in stocks, debt, derivatives, commercial paper, debentures and so on. This article is about a particular type of derivatives by the name options. In order to know in detail about options and how one can benefit from an investment in options, one must know what derivatives are and how is it related to options. Before we begin, it’s better to remember one simple aspect that in the financial market, every transaction involves two people, a buyer and a seller.

Derivatives

A derivative is basically a financial contract between a buyer and seller that derives its value from an underlying asset which does not have a value of its own but extracts a value based on its performance. By performance the indicative here is expectancy of the price movements of the underlying asset. This is mainly traded over the counter or in stock exchanges. Derivatives can be classified into many types such as options, futures, forwards and swaps. Assuming the reader knows about derivatives, let’s move on to options.

Options

As stated above options is one form of derivative and is more commonly used than most others. In options the investor is quite safe in the sense that he has the right but not the obligation to either buy or sell the underlying asset at the stated price known as strike price by the expiration date. Based on whether the investor is planning to buy or sell the asset, it is classified as call option and put option accordingly.

Example

There is a successful manufacturer of potato chips. Their input cost is based on the price movement of potato. Hence in order to minimize the company’s exposure to price movements of potato, the management decides to trade in options of potato. Hence they enter into an agreement/ contract with the potato producers in the market (say farmers) to pay a decided price (also known as strike price) for a particular quantity of potato at a given date (expiration date). If by that date, the price of potato goes higher than the strike price, then the manufacturer will be benefitted by this contract where he will exercise his control through it. He will buy the potatoes at the strike price. However, if the going price of potato is lesser than the strike price, then the manufacturer has no obligation to buy potato at the strike price. In this case on the date of expiration, the contract becomes null and void. Hence the seller can now sell his produce to anybody at any rate.

Who can get benefitted by options trading?

Options are widely used by speculators and for hedging purposes. For speculators grabbing good margins based on movement of the asset in the market may be the ideology whereas for people who use options for hedging purpose it may be to safe guard themselves from anticipated wide price fluctuations.

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