Personal Finance: Psst... Wanna Buy A Call Option?

After futures what? The two major bourses-BSE and NSE-are about to launch one of the most potent and flexible ways of hedging risks in any futures market: options trading. A guide to what the options are and how to make money trading in them.

You have just zeroed in on a flat in Mumbai that you want to buy and have forked out an initial down payment of Rs 10,000 against the total price of Rs 20 lakh. You have two months to pay the balance and take possession. But just as you are rustling up the cash and your deadline approaches, real estate prices slump and your target flat is now worth just Rs 15 lakh, although you would have to fork out Rs 20 lakh and take a loss of Rs 5 lakh. What do you do? Simple, just exercise your option not to buy the flat. True, you'll lose the Rs 10,000 you've forked out already, but isn't that better than losing Rs 5 lakh? You've just done a spot (no pun intended) of options trading and saved yourself a big loss.

How You Can Make Money
Using Index Options

Exercise Price
Expiry Date
Premium
Underlying Security
Current Price

Rs 100
3 months
Rs 5
Telco*
Rs 85

THE TRADE: The current price of Telco is Rs 85. You want to buy Telco at Rs 100 and pay an option premium of Rs 5. If Telco is still languishing at Rs 85 at the end of three months, you don't exercise the option to buy and lose just Rs 5. But, in case Telco shoots up to Rs 120, you make a clean profit of Rs 15 [Rs 120-Rs 100 (exercise price) - Rs 5 (premium paid)].

(*) for the sake of convenience, a stock has been taken as an example; trading will initially start with indices like Sensex and Nifty as their underlying assets.

Neat deal, what? But sorry folks, it's a fantasy; you can't trade options in the real estate market. At least, not yet. But you can trade them in the stockmarket. Shortly after the advent of trading index futures, the two major stock exchanges-BSE and NSE-will soon be introducing options trading, which is the most flexible way of hedging risks in any futures market. Let's do a quick round-up of what options are, how they work and, most important, how investors can make money trading options.

Options trading essentially means buying or selling an option to actually buy or sell an underlying asset at a particular price at a future date. Options are deferred delivery contracts that give the buyers the right to buy an underlying asset at a set price on or before a specified date. The key point here: while the buyer has the right to buy, he doesn't have the obligation to buy. Option buyers have the right to not exercise their option to buy an underlying asset. But option sellers have the obligation to sell and don't have the right to back out if the price hits that particular level. So, the rights of the buyer and seller are asymmetric.

Okay, so here are the basics. There are two type of options-call option and put option. A call option gives an investor an option to buy; the put option an option to sell. While both buyer and seller have the options, the rights and obligations differ. The options buyer has the right but not the obligation to buy the underlying asset but the option seller has the obligation to sell the underlying asset, but not the right. Some conventions: an American option can be exercised on or before the expiration date on the deferred delivery contract date, while the European Option can be exercised only on the expiry of the contract, which is generally three months.

All options come at a cost. Called the 'option premium', it's a charge that the buyer has to pay upfront to buy an option and to be eligible to either buy or not to buy an underlying asset at a future date at a particular price, called the strike or exercise price on the expiration date, which is the last date for exercising the option. The option premium and the exercise price get quoted and options are traded on the stock exchange.

Option values include the spot or the current price of the underlying asset, the exercise price of the option, prevalent interest rates, time to expiry and the volatility of prices of the underlying asset. While exercise price, current market price, and expiry date are predictable factors, the index volatility and interest cost created by market demand and supply are the uncertain elements in the pricing process.

The difference between index futures and index options is that when you trade in index futures, you enter into a legally binding contract to buy or sell a specific quantity of an underlying underlying asset (say the Sensex or the Nifty) at a certain price within a certain time. Once you enter into the contract, you have to buy the index future at whatever price it is at on the expiry date of the contract. For instance, if the Sensex is at 4,300 today and you anticipate it to go up to 4,500 in a months' time, you can go ahead and buy 50 Sensex futures at 4,500. One Sensex contract is in multiples of 50 units. Three months hence, if the market moves as per your prediction, you make a clean profit of 10,000 (that is 200x50). But if the Sensex falls to 4,100, you make a loss of 10,000.

With index option, the buyer pays a option premium of say Rs 10 to buy Sensex options at 4,300. If the Sensex goes to 4,500, he can still exercise the option to buy it at 4,300. However, his profit will be 190. But if the Sensex plummets to 4,100, the buyer has the right not to exercise his option. The only thing he loses then is the Rs 10 option premium, which is paid upfront. Says Manoj Vaish, CEO, Derivatives Segment, BSE: ''While the upside is open, the downside is limited to the extent of the premium paid on the option.''

Initially, like futures are, options will also be linked to indices on the BSE and the NSE. Apart from the fact that index options will be more liquid (than options or futures based on individual stocks), they also eliminate physical delivery of underlying assets (like shares), thus, saving the stock exchanges cumbersome settlement problems. Still, once the trend catches on and volumes grow, trading in individual stock options could be introduced. For the moment, with the BSE and the NSE about to flag off options trading, retail investors could try their hand at something new. Psst, wanna buy a call option on the Sensex at 4,500?