What Are Options ?

• Option is a contract that gives the buyer the right to buy or sell an underlying asset at a pre-decided price called Strike Price on or before a certain date.

• Buyer of option has always right but not the obligation. For getting this right, buyer of option contract has to pay some price to the seller of option contract. This price is called Option Premium

• Option is merely a contract which derives its value from some underlying asset. That’s why it is called a Derivative which means an option derives its value from something else.

• Buyer of Option contract is also called Holder and seller as Writer

Simple Example:
Suppose Mr. A is looking to buy a second hand car and same time his friend Mr. B is planning to sell his car. Both discussed this thing with each other. Mr. A is interested to buy his friends car but he don’t have enough money for next two months. So he talked to Mr. B and negotiated a deal as per which Mr. A has an option (not obligation) to buy car for a price of $ 10,000 in two months.  Mr. B agrees, but for this Option Mr. A has to pay the price $ 500. So in this case

Mr. A is the Holder (buyer of the option contract)

Mr. B is the Writer (seller of the contract)

Underlying asset is Car

$ 10,000 is the Strike Price

$ 500 is the Option Premium (Mr. A has to pay to Mr. B)

Expiration date is end of 2 months starting from the day they entered into contract.

Mr. A has right to buy car not an obligation (Case1: If he succeeds in arranging money in next two months he can exercise his right. He can pay $ 10,000 and take car from Mr. B Case2: If he fails to arrange money in next 2 months or finds a better deal than he can let option expiration date go at which point the option becomes worthless. If this happens, Mr. A will lose Option premium which is $ 500)

Mr. B has the obligation (It means if Mr. A decided to exercise his right than Mr. B has to sell his car to him. Even if Mr. B is getting some better deal for his car or his mood changes not to sell than also he is under obligation to sell the car. He can’t default if Mr. A exercises his right)

What is Hedging ?

Hedging:

 It’s a technique used to mitigate risk. Hedging provides insurance against some loss that may occur.

 Simple Example: Suppose you bought a car. What is risk involved?  Possible risk can be car accident & theft. So you took car insurance. Premium you paying to car insurance company is hedging. It is not going to prevent accident or theft. But your loss will be covered to some extent as insurance company will pay you back in car gets damaged in accident.

In financial markets, hedging is primarily used to safeguard your investment against possible adverse price movement. But remember Hedging is not free.  Hedging has a cost associated with it. In Hedging you safeguard one investment by making other investment. Hedging is not a profit making technique but it is used to reduce loss.

Generally it is done using financial instrument called derivatives. And most commonly used derivatives are ‘Future’ and ‘Options’

Financial Market Example:

1. Suppose you are holding shares of MNO Company. Your belief is that 1 year down the line share price of MNO will go up. But parallel to this you are expecting that for some time in the beginning (say 1-2 months)share price can fall also. So to safe guard against this short term loss you can buy a put option (give you right to sell MNO shares at a pre-decided price called strike price). If share of stock price falls below strike price you will incur loss but that loss will be offset by profit you going to earn in put option.

2. MNO is a company which produces tomato sauce. Their whole business is dependent on regular supply of tomatoes.  In addition to the regular supply, company is also worried about risk of price of tomatoes going very high in the near future. If price goes very high profit margins will suffer. So to hedge against this risk, company enters into a future contract as per which company will buy tomatoes at a specific price at a set date in the future. With this agreement now company don’t have to worry about risk of price movements and regular supply of tomatoes is also insured