Options - Limited risk, unlimited profits : (Understanding Derivatives - Part IV) - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  
  • Home
  • Outlook Arena
  • Jun 8, 2000 - Options - Limited risk, unlimited profits : (Understanding Derivatives - Part IV)

Options - Limited risk, unlimited profits : (Understanding Derivatives - Part IV)

Jun 8, 2000

Having seen the mechanics of futures, we shall delve into what an option is. For the purpose, we shall revisit the story of Chandar the rice farmer. In the example of Chandar, we find that he is quite comfortably placed now. But let us consider some possible risks that Chandar faces. Chandar, when he has entered into a futures contract he has booked the price at which he will sell his rice that will be harvested. In case there is a crop failure, Chandar would be forced to buy rice from the market and deliver or square off the futures contract as would be prevalent then. If the crop failure is general in nature, the price of rice would be high and hence rice futures would also quote at higher prices. In such a scenario, Chandar would be left with heavy losses in hand.

Alternatives that we have seen with Chandar this far are

  • Get into a forward contract with Thakur
  • Sell Rice futures
  • Or, do nothing and bear the price risk.

    Chandar as we read in the previous article could buy put options on his rice. Put options by definition give the holder the right to sell the commodity at a given date and a given price. He may choose not to exercise the right.

    Let us suppose Chandar buys a put option, which allow him to sell 20 tons of rice at Rs 5 per kg to Thakur after three months. Thakur sells this right to him at a price of Rs 1.5 per kg. Thus Chandar has ensured that he will realize a minimum of Rs 3.5 per kg net. In case the price of rice in the market is more than Rs 5 per kg, Chandar may choose to sell his produce in the open market rather than to Thakur without him having any right to enforce performance on Chandar. Having seen a put option that gave Chandar the right to sell, we shall explore what is a call option. A call option gives the holder the right to buy the underlying asset at a given price on or before the specified time.

    Let us continue with the example of Chandar.

    Chandar has estimated that he would need ten labourers to help him in his harvesting. In case, he has a bumper crop, he will need three additional men to help him. During harvest time, labourers are always in demand and one has to book the labourers in advance and the rates can go as high as Rs 150 per labourer. A single labourer for one day costs him Rs 75/- though he does not have to pay any advance. An oral commitment is enough. But now he is unsure whether he needs ten labourers or thirteen. So he offers three labourers Rs 25/- on promise that they will work for him at the rate of Rs 75/- per day only if he needs their help on those particular days. Chandar may choose not to hire them then, and has paid Rs 25/- as compensation for this arrangement.

    To summarize the chapter on options, we could say,

  • An option confers a right and does not constitute an obligation like in the example Chandar had the choice whether to sell rice to Thakur at the price and whether or not to hire the three additional labourers. In either of the two cases, Chandar could not be forced to sell rice at the price or to hire the labourers.

  • It could be to buy or to sell like Chandar bought a put option to sell his rice and a call option to buy labour.

  • Call Options (the right to buy) are like bookings done with the payment of a token. If the booking is cancelled, the token gets forfeited. Example: Booking a car.

  • Put Options (the right to sell) are like insurance contracts that guarantee you a minimum realization for your assets Chandar has assured himself of a certain minimum realization for his rice.

  • Options come with a premium. This premium is a complete loss if the right is not exercised. Chandar has paid 30% of the sale value of rice to Thakur to buy the put option. They may be treated as a part of cost.

  • Some options can be exercised at any time during its' life. Such options are called American Options. For example, Chandar would not be sure whether he would harvest his crop in two months or two and a half months. Therefore, he will enter into an agreement whereby he can exercise his option anytime during three months.

  • Some options can be exercised only during a specified period. These options are called European Options. Chandar has booked the labourers for some specific days. Chandar would be able to buy their services only on that day for which he has booked them.

  • This article is one of four articles in a series to understanding derivatives. Read Part I, Part II and Part III of this series

  • Equitymaster requests your view! Post a comment on "Options - Limited risk, unlimited profits : (Understanding Derivatives - Part IV)". Click here!

    1 Responses to "Options - Limited risk, unlimited profits : (Understanding Derivatives - Part IV)"

    Ketan Vora

    Jun 14, 2009

    The details are really helpful

    Like 
      
    Equitymaster requests your view! Post a comment on "Options - Limited risk, unlimited profits : (Understanding Derivatives - Part IV)". Click here!

    More Views on News

    It's Time to Book Profits (Fast Profits Daily)

    Nov 27, 2020

    In my first video on Equitymaster, I want to introduce you my proprietary greed and fear index. It's telling us to book some profits in the market.

    Mirae Asset Large Cap Fund: Participating in High Quality Businesses (Outside View)

    Nov 27, 2020

    PersonalFN's analysis on the features and performance of Mirae Asset Large Cap Fund.

    Create Wealth for Yourself in India's Drone Revolution (Profit Hunter)

    Nov 27, 2020

    The Chinese drone market is 14 times that of India's. Billions may flow into Indian drone companies too. Don't miss out on this wealth creating opportunity.

    Two Very Important Updates For You (Fast Profits Daily)

    Nov 26, 2020

    In this video, I'll have an update for you on gold and the new member of my team.

    Adani Green: A Future Multibagger or a Big, Speculative Bubble podcast (Views On News)

    Nov 26, 2020

    Rahul Shah discusses the hype around Adani Green Energy and analyses whether it is justified.

    More Views on News

    Most Popular

    Not Infosys or Wipro. India's Next Wealth Creators Could Be Drone Stocks (Profit Hunter)

    Nov 25, 2020

    India's drones directorate signals the next big defence tech multibaggers.

    Stocks that Could Shine More than Gold After Diwali (Profit Hunter)

    Nov 17, 2020

    If the markets become volatile over the next few months, do this.

    How the New Margins Will Impact You (Fast Profits Daily)

    Nov 25, 2020

    The new rules on margins will come into effect from 1st December. Are you ready?

    How to Build the Best Trading System (Fast Profits Daily)

    Nov 20, 2020

    In this video, I'll show you how to make the best trading system.

    An Eraser and Some Pencils (The Honest Truth)

    Nov 17, 2020

    Ajit Dayal on the road ahead for the world after covid.

    More

    Covid-19 Proof
    Multibagger Stocks

    Covid19 Proof Multibaggers
    Get this special report, authored by Equitymaster's top analysts now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Nov 27, 2020 (Close)

    MARKET STATS