Understand Options with a Simple Example

Consider a scenario. You track market dynamics and you come to know that interest rate is going to go down in next 3 months. The government wants to increase liquidity in the market to increase consumption. The logic that most Governments give is that if the interest rate is low, you will not put your money in banks as they offer lower deposit rates, meanwhile you spend some of the money or look for alternate investments.

One investment option is stock market; but it is too risky for most of the people. Hence they invest in time tested assets, i.e. gold and land. We will look at gold in our case to show the meaning of option. Based on this analysis you conclude that gold demand will rise and hence prices of gold will also go up. How can you take advantage of the situation?

What if you get the right to buy gold in 3 months at the rate of Rs 1100 per gram? The current rate is Rs 1090 per gram. You may have arrived at your conclusion that gold will rise above Rs 1100 per gram in 3 months. Of course, if the government doesn’t lower interest rate, the gold prices may not even go beyond the existing Rs 1090 per gram in 3 months. Let’s say you are not obligated to buy gold if it doesn’t go beyond Rs 1100 per gram. This is a great situation to be in, isn’t it? This is option for you, or more precisely call option. A call option is a right but not an obligation to buy an underlying asset at a specified price at a specified date.

Consider one more scenario. You come to know that Government is going to increase the interest rate to tame inflation. Usually when the interest rates go up, people put their money in bank to avail high interest available. Corporates slow down their expansion plan because of high cost of borrowing. The market moderates and comes down. How can you take advantage of this situation? You will want to have right to sell your index option on a future date at a price determined now. Since you know the prices will go down, you go into a contract deciding the strike price (price at which the transaction takes place). If the price really goes lower than the strike price, you make money. If it doesn’t, you have nothing to lose anyway as you bought the right to sell but you don’t have to sell if you don’t want. This is put option for you.In this case, you have right but not the obligation to sell an underlying asset at a specified price at a specified date. We will discuss options in detail in further articles.

How do you get these wonderful rights to buy or sell but not the obligation? This is where you pay premium to buy this right. This premium or price you pay is known as option price.

Index options and stock options are some of the most traded options in the stock markets around the world.