We will be discussing about Options Contracts and how they are different from Futures – from buyers’ perspective.

We will be discussing about Options Contracts and how they are different from Futures – from buyers’ perspective.

In futures contracts, theoretically there is a possibility of unlimited profit and unlimited loss. If we trade in a Futures contract, we have an obligation to bear that loss, or gain profits as the case may be, depending on the spot price on expiry. If we enter into a contract to buy or sell an asset at a particular price, on expiry, we will have the obligation to fulfil it, irrespective of the current market price. Right?

Now, what happens if we have a choice? Or a right? If a derivatives contract can give us a choice or a right, a right to enter into the contract or simply back out at a later stage. What if we don’t have an obligation to fulfil the contract?

Do you think the choice or right is available? The answer is yes.

This choice is called an option, a type of derivatives contract that gives you a choice. A choice or the right to buy or sell the asset at a predetermined price and time.

Now think about it – if in a contract, one party has a Choice or right to enter or not enter the contract as per the situation, the other party has to take an obligation. So, a few things to note here are –

When you chose to take up the right – you are the buyer of that choice or right

When you chose to take up an obligation – you are the seller of that choice. So, this choice can be bought or sold.

Assume you are bullish on a stock. It is trading at Rs.670/- today. You have the right today to buy the same stock one month later, say, at Rs. 750/-. Now If the share price on that day is more than Rs. 750? You would buy it. It means that, after 1 month, even if the share is trading at Rs. 850, you can still get to buy it at Rs.750. In order to get this right, you are required to pay a small amount today, say Rs.50/-.

If the stock price moves above Rs. 750, you can exercise your right and buy the shares at Rs. 750/-. If the share price stays at or below Rs. 750/- you do not exercise your right and you do not need to buy the shares. All you lose is Rs. 50/- in this case. An arrangement of this sort is an Options Contract.

After you get into this agreement, there are only three possibilities which can occur.
And they are-

1. The stock price can increase, say, to Rs.850/-
2. The stock price can fall, say, to Rs.650/-
3. The stock price can remain the same at Rs.750/-

So, If the stock price goes up, then it would make sense to exercise your right and buy the stock at Rs.750/-.

The P&L would look as shown on the screen:

Price at which stock is bought = Rs.750
Premium paid =Rs. 50
So, total expenses incurred = Rs.800
Current Market Price = Rs.850
Profit = 850 – 800 = Rs.50/-

Case 2 – If the stock price goes down to say Rs.650/-, obviously it does not make sense to buy it at Rs.750/- as effectively you would be spending Rs.800/-, that is Rs. 750+ Rs. 50, for a stock that’s available at Rs.650/- in the open market.

Case 3 – Likewise if the stock stays flat at Rs.750/- it simply means you are spending Rs.800/- to buy a stock which is available at Rs.750/-, hence you would not invoke your right to buy the stock at Rs.750/-.

So, we understand that in an options contract, one person who is paying a small amount to buy the choice or right is the option buyer. His risk or loss is limited to the amount of money he has paid to buy this right. This amount is called the options premium. The other party who sells this right by receiving the premium is known as the options seller.

So, an options contract helps you manage risks better than a futures contract.