In a civilised society, rights and obligations are matched. If you rent a house, you have the right to live in it and the obligation to pay rent, while the landlord has the right to get rent and the obligation to let you live in it. If either side does not meet its obligation, it loses the corresponding right.
In a less decent and civilised situation, people demand everything as their right but do not feel obliged to follow any rules or do anything in return.
But what if you could (legally) acquire a right, but have no corresponding obligation? Too good to be true? Ah, enter the Option.
Let us say “a young man, in possession of a good fortune, is in the want of a suitable girl.” If he finds one such, and she agrees, they get engaged. This gives both the boy and the girl the right to get married and the obligation to be married.
Suppose the young man does find a suitable girl, but he is not quite sure --there might be a better girl out there. At the same time, he does not want to miss the chance of marrying this girl if he finds none better. So, he makes this (somewhat outrageous) proposition to the girl…
“I want six months to do some more searching, and if I do find a better girl, I won’t marry you. But if I don’t, I will marry you six months from now. In the meantime, you cannot get married to anyone else, and if I come back to you after six months you must marry me.”
I put this proposition to a bunch of ladies in Abu Dhabi and asked if any girl would agree to it. There was a vociferous “No!!” in chorus.
Then I added: “What if the boy pays her $1 million for this deal?”
The ladies looked at one another and most of them nodded – yes.
Jokes apart, this is how an option contract works.
You can get a right, without any obligation, by paying a fee (premium) up-front. This right can be exercised on a known future date, but only if you wish to do so (because it is profitable).
I will try to explain how it works, with minimal jargon.
Let us say you feel bullish about XYZ Corp and expect the stock price to rise from its current level of Rs3,000. If you have Rs3,000 to invest, you could buy one share.
If the stock climbs, your gain is limitless. If it falls, you could lose your capital. You can play on your expectation in another way through an option, which will give unlimited upside and limited downside.
You can buy one call option contract (representing one share) at a ‘strike price’ of Rs3,000. This contract is for a limited period, which will give you the right to buy one share of XYZ at Rs 3,000 on a ‘future date’ (say one month from now).
The options are traded and the price paid is called a ‘premium’. The value of one call option contract, say, is Rs100 per one. Your Rs3,000 will get you 30 contracts of one share each, whereas if you were buying shares of XYZ, you would have got one share for Rs3,000.
Now see what happens.
- If the stock remains at Rs3,000 or less, the value of your option goes down. At the end of one month, they become worthless because the right to buy at Rs3,000 gives you no gain. You lose Rs3,000—the premium.
- If the stock goes to, say, Rs3,300 on the stipulated ‘future date’ (called the expiry date) you will be able to buy 30 shares at Rs3,000 and immediately sell them at Rs3,300, gaining Rs9,000 (Rs300 x 30 shares). This will be a ‘paper’ transaction with no outlay of money. Deduct the premium of Rs3,000 you paid earlier, and your net gain is Rs6,000 (200% of your investment of Rs3,000).
Compare this with buying one share at Rs3,000 and selling it at Rs3,300—a gain of Rs300 (10%).
As you can see, the option leverages (magnifies the impact) of your investment hugely. Also, your maximum possible loss is Rs3,000 (the premium you paid for buying the option) while your maximum profit is unlimited. If the stock goes to Rs4,000 you will gain Rs27,000.
The same way, if you are bearish on XYZ Corp and feel that the stock is going to fall, you can do the opposite of the above - buy a put option, which gives you the right (but not the obligation) to sell.
Assuming the premium is also Rs100, your maximum loss will be Rs3,000 (If the stock does not fall) but your maximum gain will be unlimited. If it falls to Rs2,000 you will gain Rs27,000.
Let us say you feel that some forthcoming major event (a change in government policy, perhaps) will either benefit or harm XYZ Corp significantly, and the stock will move sharply either up or down.
But you are not sure which direction.
You can then do a ‘straddle’, i.e., buy a call and a put simultaneously at the same strike price for the same expiry date. For Rs3,000 you will get 15 call contracts and 15 put contracts.
If nothing happens, and the stock remains within Rs2,900 to Rs3,100, neither of the two option will have any value. But, if the stock goes to, say Rs3,300 you will gain Rs4,500 on your call option (zero on your put option). So, your net gain will be Rs1,500 – 50%, not bad!!
Similarly, if the stock falls to Rs2,700 you will make money on your Put (nothing on the call) and your net gain will be Rs1,500.
Good fun, right? In how many aspects of life can you make a bet with lower relative risk and higher relative reward?
Academics call such situations asymmetric bets.
In options, you know upfront how much you can lose in the worse-case scenario—the entire premium you paid. Your gains, on the other hand, are unlimited.
If you can afford to lose the entire premium, you can try for a large gain which could give you a huge return on your investment.
There are other interesting things you can do with options. Also, you can buy options on many other things—Nifty, gold, commodities etc.
Hold on! What about the guy who is taking your premium and giving you a right without any obligation? Is he a damn fool?
Ah, but that is another story!!
(Deserting engineering after a year in a factory, Amitabha Banerjee did an MBA in the US and returned to India. Choosing work-to-live over live-to-work, he joined banking and worked for various banks in India and the Middle East. Post retirement, he returned to his hometown Kolkata and is now spending his golden years travelling the world (until Covid, that is), playing bridge, befriending Netflix & Prime Video and writing in his wife’s travel blog.)