Option Trading in Shares and Stocks
When an option contract is entered into with an option to buy or sell shares or stocks, it is known as ‘share option’. Share option transactions are generally index-based. All calculations are based on the change in index value. For example, the present value of the index is Rs.300 and the strike price or exercise price is Rs.350.
So long as the index remains below 350, the option holder will not exercise his option since he will be incurring losses. Now, the loss will be limited to the premium paid at the rate of Rs. 10/- per point. As the spot price increases beyond the strike price level, exercise of the option becomes profitable. Suppose the spot rate reaches 360, option may be exercised. The option holder gets a profit of Rs. 100 (10 points x 10). However, his net position will be Rs. 100-300 (premium 10% on 300 x 10). He incurs a net loss of Rs. 200. When the spot rate reaches 380, the break even point is reached. Beyond this index value, the option holder starts making a profit.
A person with more money can trade the index at a higher rate of Rs.100 or 200 per index point. However, this kind of game can be played by speculators only. Genuine portfolio managers can use this instrument to hedge their risks due to heavy fluctuation in the prices of shares and stocks.
Suppose an option contract is entered into between two parties to purchase or sell foreign exchange, it is called ‘currency option’.
This can be illustrated by an example.
An option holder buys in September, dollar at the exchange rate of 1 ₤ = 1.900 $ maturing in November. The spot rate then was1 ₤ = 1.875 $. The strike price therefore is 1 ₤ = 1.900 $. Suppose the purchaser also pays a premium of 7.04 cents per ₤ 1. As long as the price of pound in the market remains below 1.900 $, the option will not be exercised. Ofcourse the option holder suffers a loss, but his loss is limited to the premium paid at the rate of 7.04 cents per ₤ 1. When the spot price increases beyond the strike price, it is profitable to exercise the option. For instance, the spot rate becomes 1.9200 $ per ₤ 1, if the option holder exercises his option now, he will get a profit of .200$ per ₤ 1. However, his net position will be .0200-.0704 (premium) = -.0504 $ (loss). If the spot rate goes upto ₤ 1 = 1.9704 $, the break even point is reached. Beyond this level, the option holder gets profit by exercising his option.
On the other hand, the writer of the option gets profit as long as the option is not exercised. His profit is limited to the premium received i.e., 7.04 cents per ₤ 1. When the spot rate goes beyond the strike price, the option holder will exercise his option. At the rate 1 ₤ = 1.9704$ the writer of the option is also at the break even point. If spot rate goes beyond this level, the option writer will suffer a net loss.