From THE HINDU group of publications
Sunday, July 22, 2001


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What `options' do you have?

AN OPTION is a contract which gives the right, but not the obligation, to buy or sell the underlying at a stated date and at a stated price. A call option gives the right to buy and a put option gives the right to sell.

A typical options transaction takes the following form:

*On December 1, 2000, `A' sells a call option (right to buy) on `ABC Ltd.' to `B' for a price of, say, Rs 3.

*Now `B' has the right to approach `A' on December 31, 2000 and buy 1 share of `ABC Ltd.' at Rs 5.

*Here Rs 3 is called the option price, Rs 5 is the exercise price and December 31, 2000 is called the expiration date.

*`B' does not have to necessarily buy 1 share of `ABC Ltd.' on December 31 at Rs 500 from `A'.

*`B' may find it worthwhile to exercise his right to buy only if `ABC Ltd.' trades above Rs 500.

*`B' exercises option, A has to necessarily sell `B' one share of `ABC Ltd.', at Rs 500 on December 31, 2000. So if the price of `ABC Ltd.' goes above Rs 500, `B' may exercise his option, or else it may lapse. Then `B' loses the original

option price of Rs 3, and `A' gains it.

The farmer analogy

The general example taken for explaining the concept of derivatives is the case of a farmer. A farmer expecting a harvest could do any of the following:

*Do nothing and bear the downward price risk on his crop. This may cost the farmer too much in case of a drastic fall in the price.

*Enter into a bilateral arrangement with a prospective buyer. The counter-party risk could prove to be high.

*Sell futures on the crop (it is assumed that such futures contracts are available and traded in an exchange).

*If there were no crop failure, the farmer, as planned, would deliver the harvest at the predetermined price.

*In case of a crop failure, the farmer would be forced to buy the crop and deliver or square off the futures contract as would be prevalent then.

*If the crop failure is general in nature, the crop's price may be high and, hence, the futures may quote at higher prices and the losses could be hefty.

*Buy put options on the crop.

*Put options, by definition, give the holder the right to sell the commodity at a given date and a given price.

*Assuming the price of the put options is Re 0.50 per kg, and assuming that the option's strike price (at which the farmer will be able to sell the crop at the expiation of the contract) is Rs 6 per kg, if the price of the crop goes above Rs 6 per kg after three months, the farmer will sell his proceeds in the market and will not exercise his right.

*If he sells the crop at, say, Rs 7 per kg, he will get a net price of Rs 6.50 (the selling price less the premium paid). If the price falls down below Rs 6, the farmer will exercise his right to sell at Rs 6 per kg and is assured of a price of Rs 5.50 per kg (the selling price less the premium paid).

In case of a crop failure, the maximum loss would be restricted to Re 0.50, that is, the cost of the put option. Thus, options prove to be an effective risk-management tool.

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Who should trade in options?

Investors belonging to the following categories, depending on their financial goals and investment objectives consider options trading.

*Investors who want to participate in the market without trading or holding a large stock portfolio.

*Those with strong views on the market and its future movement, and want to take advantage of the same.

*Investors who follow the equity market closely.

*Investors who want to protect the value of their diversified equity portfolio.

Why trade in Options?

Buying options can be compared to buying insurance. For instance, you buy insurance and pay premium to cover the risk of burglary or fire. In the event of any untoward happening, the insurance cover compensates for the losses.

Otherwise, the insurance cover expires after the specific period of time. The insurance premium is the cost for the cover. Similarly, in the case of options, the right to buy or sell the underlying is acquired by payment of a premium.

This affords protection against a general fall in market and, thus, can be attractive to various parties, including Mutual Funds. The option could be exercised in the event of adverse market movement. Else, the option will expire after the specific period.

The cost of the option, that is, the premium, is paid at the time of purchase. There is no further loss generated by the option for the buyer. This feature makes options attractive for market participants.

Options can be traded on individual securities or Indices. NSE introduced options on S&P CNX Nifty (Nifty options) on June 4, 2001. Options on individual securities would be introduced very soon subject to necessary approvals. The contract specifications of options contract at NSE are as follows:

Nifty options allow the investor to trade a large segment of the equity market with one decision and, thus, provide a different perspective to investing in equities. Nifty options help the investors reflect their views on the market -- bullish, bearish or neutral -- to plan their investment strategies and trade efficiently.

What is S&P CNX Nifty?

S&P CNX Nifty (Nifty) is a 50-stock index comprising the largest and the most liquid companies in India. Nifty covers nearly 25 sectors and a market capitalisation of almost 49 per cent of the total market capitalisation. The ownership and management rights of this index rests with India Index Services and Products Ltd. (IISL), a corporate body jointly promoted by NSE and the Credit Rating and Information Services of India Ltd., a credit rating agency in India.

IISL has a co-branding and licensing agreement with Standard and Poor's (S&P), one of the world's leading index services providers. Nifty is a scientifically developed market capitalisation weighted index with the advantage of technical oversight by S&P. Nifty was developed keeping in mind that an index, besides being a true reflection of the stock market, should also be used for modem applications such as index funds and index derivatives.

(To be continued)

(Edited-extracts from the latest NSE News published by the National Stock Exchange of India. The author is Mr R. Sundararaman, Head - Futures & Option Segment, NSE.)

Section  : Personal Finance
Previous : On to the next generation
Next     : Options: Some basic terminology

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