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Options in Finance

In finance, Options is the famous financial instrument in derivative market. In simple words, option is the contract between buyer and seller with the condition that buyer will have option to use his right for future transaction but not obligation. Sellers will have both rights and obligations.

Example of Option Contract 

Option contract is totally different contract from forward contract. We can explain it clearly with following example.

 For example, if buyer fix the price of buying product with $ 10 after 60 days under option contract. If the price will be $ 9, at that time, for buyer there is not necessary to buy it because he will get the loss for buying this product costly with strike price. In other case if the prices will be $ 11 after 60 days, buyer can use his option right  for buying because he is getting profit in this deal. At that time seller has no option, he will just capture in his commitment obligations under option contract.

From above example, you have learned that seller has to do this contract after full estimation. Otherwise, there is only loss of seller.

Types of Options

1. Calls Option

In call option, buyer has right to acquire the underlying asset or not. But seller has not same right. He has only obligation to deliver the asset, buyer chooses  his right option.

Now, question is why calls option contract will happen in current time?

=> Buyer  is thinking that price will increase and he will earn big profit with strike price.

=> Seller  is thinking that either price will not rise or he is satisfy with money paid by buyer for accepting call option contract. This money is called premium.

 Example of Call Option : 

ABC Company's current market value is $ 100 per share. Mr. Mohan has 1000 shares. He want to sell immediately through call option contract. Mr. Sohan expects that price of same shares will increase upto $ 110 per share. He is ready to enter in this call option contract. For this, he has to pay $ 10 per share. If it will not become $ 110 per share, he will have the option right. If shares value will not reach upto $ 110 per shares, he can leave this contract. Now, this time paid only $ 10 per share. For this, he paid $ 10 X 1000 = $ 10,000

Now, there are two options for buyer.

A) Before expiry of contact, market price does not rise. Buyer does not buy 1000 shares at $ 110. He lost only $ 10,000 and save further losing of $ 10,000 due to exercising this contract.

B) Before expiry of contract, market price reached at $ 130 per share. Buyer exercise this contract and bought all by paying just $ 110 per share. For this, he paid only $ 1,10,000 and

Total gain = $ 1,30,000 - 1,10,000 = $ 30,000

Net Gain = $ 30,000 - $ 10,000 = $ 20,000

2. Puts Option

Put contract is mainly benefited to seller. If there is chance of falling the prices. Seller can do puts option contract with buyer. In this option, seller has right not to sell and buyers will only buy under obligation of put option contract at strike price.

=> Buyer  is thinking that either price will not decrease or he is satisfy with money received from seller upto falling price under put contract. This money is called premium.

=> Seller   is thinking that price will fall  and he will earn big profit with strike price which is less fall than exact fall in the future prices.

Example of Put Option :

ABC Company's current market value is $ 100 per share. Mr. Mohan has 1000 shares. He want to sell immediately through put option contract. Mr. Mohan expects that prices of this shares will fastly fall. So, he is ready to fix strike low price. Mr. Sohan is interested to buy at low price under put contract. Strike price is $ 90 which is less than current price. Now, strike price is $ 10 less. So, seller will pay $ 10 per share to buyer.  So, seller paid $ 10 X 1000 = $ 10,000 at this time. Now, seller has right to leave the contract, if prices will not fall. Buyer has obligation to buy the shares at strike price if prices will fall upto the expiry of contract or maturity.

 For this, he has to pay $ 10 per share. If it will not become $ 110 per share, he will have the option right. If shares value will not reach upto $ 110 per shares, he can leave this contract. Now, this time paid only $ 10 per share. For this, he paid $ 10 X 1000 = $ 10,000

Now, there are two options for Seller.

A) Before expiry of contact, market price does not fall. Seller does not sell 1000 shares at $ 90. He lost only $ 10,000 and save further losing of $ 10,000 due to exercising this contract.

B) Before expiry of contract, market price reached at $ 70 per share. Seller exercise this contract. He sold $ 70 price per share at $ 90 per share under put option.

Total gain = $ 90,000 - 70,000 = $ 20,000

Net Gain = $ 20,000 - $ 10,000 = $ 10,000




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Accounting Education: Options in Finance
Options in Finance
Accounting Education
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