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

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  • 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

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

    Ketan Vora

    Jun 14, 2009

    The details are really helpful

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

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