Those of us who are in the mid-50s or late 50s have never understood derivatives very well. Personally, my CA course has never mentioned the word derivatives when I finished my CA in 1987. Back then we were in a closed economy and Nobel prize-winning economists Robert Merton and Mycron shoes published their Stock Option model only in 1973.
In the closed economy that we were in, India started options trading for stocks only in the current millennium, after the advent of NSE. In less than eight years, the subprime crisis struck the whole world due to the indiscrete use of derivatives.
Given this anathema, personally, I have never been interested in derivatives. Instead, we are strong believers in enterprise valuation and pitching it against market valuation. Of late though personally, I wanted to understand the options pricing model. This blog series is my bitd to understand it clearly. So this is more for me than for others.
Options apparently have been in vogue from time immemorial. Accordingly to Investopedia the first use of options were done by ancient Greek to speculate on the olive harvest. So we are talking about BCE times and a history of over two millennium.
With so many options jargons floating around the options and futures market, it can be overwhelming. If one throws the terms call, put, buyer and seller risk, time decay, implied volatility, option Greeks, Delta, Gamma, Vega, Theta, long and short options, in the money, out of the money, at the money or close to money options into a basket and have a look into it, they will be lost totally and one will decide not to go near the derivatives market. That’s exactly what I did about a decade back. This is despite the fact every one of us has entered into an options contract at some point of time.
We decide to buy a house worth say one crore. We tell the buyer we will buy the house within three months and pay an advance. We need the time to raise bank loans and organize our initial payments. We crystalize the price and pay an advance of Rs.2 lacs. This is a quintessential options contract.
This obviously is different from a standard buy and sell contract. Let us say Reliance share is quoting at Rs.2400/ per share. The seller gets Rs.2400/- and he is obliged to give one share. The buyer is contractually entitled to receive one share by virtue of his having paid Rs.2,400/-. This is a clean transaction.
Options are a little complex perhaps due to the fact duties and liabilities of the buyer and seller are not the same. They are asymmetrical in nature.
The seller of the building has to contractually transfer the title before the expiry of three months, once he receives the balance payment of Rs.98 lacs. The buyer on the other hand is not contractually liable to buy the property. He goes scot-free so long as he is willing to forfeit the advance paid. This asymmetry defines options contracts.
Let me restrict myself to call options and that too buy-side in this blog. Self-side options and buy and self-side put will be better appreciated after understanding options dynamics.
At the money/close to the money contracts Reliance is quoting at Rs.2,400/- on the expiry day. For this, the seller will charge the premium and the actual cost of the shares is Rs.2,400/- + the premium charge, say Rs.50/-. Seller is supposed to deliver the shares by taking another Rs.2,400/- regardless of the share price. If the share price is Rs.2,500/- on the expiry day, buyers gain Rs.50/- profit and if the share price is Rs.2,350/- on the expiry day, the seller loses Rs.50/-. The market is dynamic and at the money is impossible to achieve. So they are more like close to the money contract.
Out of the money, contracts are typical bull expectations. I can contract with the seller to buy the Reliance share at Rs.2,500/- at a later date (expiry date). The rest of the parameters remain constant. Buyer profits if the price on the expiry day is more than Rs.2,500/- (strike price) plus the premium he is expected to pay. Because the buyer is willing to pay a higher price his premium payment will be much less. He will be obliged to pay a premium of say Rs.25/- instead of Rs.50/-. Break-even for buyers is Rs.2,525/- per share and the gain or loss of the seller (including premium) difference between Rs.2,525/- and the actual closing price on expiry day.
In the money contract happens when the call buyer says that he would buy the shares at Rs.2,350/- on the expiry day. Funny as it may sound it has a solid basis. The share price is already Rs.2,400/- and the contract price leaves an intrinsic value of Rs.50/-. In this case, the total contract spread will be the intrinsic value of Rs.50/- + the premium of Rs.50/-. So the buyer will have to pay Rs.100 at the time of contract
So, out of the money call option involves reduced premium and is hence the cheapest. At the money or close to the money contracts involve just the premium. In the money, contracts have an intrinsic value component + full premium.
Given the scenario, how on earth someone will make money or lose it and that too in millions with these seemingly innocuous contracts. Understanding that involves studying a few graphs and a bit of mathematics.
Let me leave it here and continue later.