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I hope the last lesson on Options helped you in getting to understand the concept. In continuation of that, we also discussed the Call option for your clarity on the subject.
Having explained the Call option, quite naturally, youll want to know about the Put option. Let me try & explain to you how this kind of an Option Deal is practically done in the market place.
In the stock market there are several participants who are both buyers and sellers
This is so that the current stock price is known to every participant (buyers and sellers) Any participant trying to extract a higher price will not be able to do so because of the free flow of information which prevents any sort of price arbitrage. This is what we call Price Discovery.
Now lets say there is a stock option on stock A, which is currently quoting at Rs.100. And lets say the option expires after 5 days
Hence he chooses to buy a put option which protects him against any rise in price. For getting this service, he would have to pay a premium to the seller of the option. The seller of the option, Shyam, on the other hand has a view that the price of the stock will rise.
(either)
Selling the stock to Shyam at the pre-agreed price of Rs 100 (or)
In other words, Ram is given the option of not honoring the contract made with Shyam on the date of settlement.
However, it is not that bad a situation for Shyam as it appears as he gets compensated by Ram for having been a party to the Options contract. This compensation * in the form of price is called the Option
Premium that Ram has to pay for the Options contract and is
usually a small amount. Lets assume in our case the amount is Rs 2. So Ram is obliged to pay Shyam Rs 2 towards the cost of compensation for having such an option.
* Please note that the Ram will have to pay an option premium regardless of whether or not the option is actually exercised.
To understand this better, lets assume that Ram has bought a put option at the strike price of Rs. 100 (i.e. the price at which he gets a right to sell the stock A in the future to the seller of the put option i.e. Shyam). Now, look at how the prices move in these 5 days and what implications it has for Ram & Shyam
Day 1
It is important to understand that this trade starts with a debit balance of Rs 2 ( the premium) in the buyers (Ram) account while the sellers (Shyam) account would show a credit balance of the Shyame amount ( Rs 2 Premium amount). Further, it is imperative to know that Rs. 2 is the maximum debit and credit which can occur in Rams and Shyams account respectively.
Ram Buyer
Shyam Seller
Debit
Day 1
Rams buying price of the Option on day One 100 Closing Price on day One 98 His notional profit at the end of day One Rs. 2 But, unlike futures, Rams account will not be credited by this profit till he settles or squares off his contract. However, Shyams account would be debited by Rs 2 since he is obliged to honor the contract.
Ram Buyer
Shyam Seller
Debit
Day 1
Rs 2
Day 2
Closing Price on day two 95
Ram Buyer
Shyam Seller
Debit
Day 1 Day 2
Rs 2 Rs 3
Ram can cash out his notional profit today by assigning his put option to Shyam. Shyam cannot exit the contract; however; he can pass on his probable future obligation to some other participants by honoring the losses till date.
Day 3
Closing Price on day Three 96 Rams notional profit comes down to Rs. 4 and Shyams account would get credited by Rs 1.
Ram Buyer
Shyam Seller
Debit
Rs 2 Rs. 3 Rs 1
Ram can cash out his notional profit today by assigning his put option to Shyam. Shyam cannot exit the contract; however; he can pass on his probable future obligation to some other participants by honoring the losses till date.
Day 4
Closing Price on day Four 97 Rams notional profit will come down to Rs. 3 and
Debit Premium Rs 2
Credit
Debit
Credit Premium Rs 2
Rs 2
Rs 2
Day 2
Day 3 Day 4 (notional profit Rs. 3) Rs 1 Rs 1
Rs. 3
Day 2
Day 3 Day 4
Rs. 3
Rs 1 Rs 1
Ram can cash out his notional profit today by assigning his put option to Shyam. Shyam cannot exit the contract; however; he can pass on his probable future obligation to some other participants by honoring the losses till date.
Debit
Credit Premium Rs 2
Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4
Ram Buyer
Day 1 Day 2 Day 3 Day 4 Day 5
Debit Premium Rs 2
Credit
Shyam Seller
Day 1 Day 2 Day 3 Day 4
Debit
Credit Premium Rs 2
Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4
Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4 Rs 9 Rs 7 Rs 2
Total
Rs 2
Rs 9
Ram Buyer
Day 1 Day 2 Day 3 Day 4 Day 5 Total Net gain
Shyam Seller
Day 1 Day 2 Day 3 Day 4 Day 5 Total Net Loss
Debit
Credit Premium Rs 2
Rs 2 Rs. 3 Rs 1 Rs 1 Rs 4 Rs 9 Rs 2
Rs 7 Rs. 2 = Rs. 5
Phew! That was quite a tough one. I hope you have got
Please do let me know if I have managed to clear this concept for you. Your feedback is very important to me as it helps me plan my future lessons. Please give your feedback at professor@tataamc.com
Disclaimer
The views expressed in these lessons are for information purposes only and do not construe to be of any investment, legal or taxation advice. They are not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk and Tata Asset Management Ltd. will not be liable for the consequences of any such action.