MECHANISM OF DERIVATIVES PART-II “OPTIONS” BY MANSUKH JANUARY 2011

Options, the most complicated instrument of the capital market is widely used to trade while investing in mutual funds, stocks and bonds. Options are complex securities and can be extremely risky. This is why, when trading options, you'll see a disclaimer like“Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital”. Basically “An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.


Options can be divided into two parts, call option and put option.
Call Option: A call gives the holder the right to buy (but not the obligation)      an asset at a certain price within a specific period of time. Calls are similar to
having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

Put Option: A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having  a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market 
There are four types of participants in options markets depending on the position they take. These are Buyers of calls, Sellers of calls, Buyers of puts, Sellers of puts. People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. The main difference between the buyer and seller is that. Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. While Call writers and put writers (sellers), however, are obligated to buy or sell.

Use of Options
Options are used generally for two purposes either for speculating or for hedging. The advantage of options is that it is limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the pure form of betting on the movement of the stock in which the big money is made and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement.

Hedging is just like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit.

Types of Options
There are two types of options which are used to trade in different exchanges. American options which can be exercised at any time between the date of purchase and the expiration date. The example about a Reliance Industries is an example of the use of an American option. Most exchange-traded options are of this type. While on the other hand European options are different from American options in that they can only be exercised at the end of their lives.

Conclusion: In this section of the tutorial we hope it has given you some insight into the world of options. Once again, we must emphasize that options aren't for all investors. Options are sophisticated trading tools that can be dangerous if you don't educate yourself before using them. Please use this tutorial as it was intended as a starting point to learning more about options.