Thus, Options are more flexible for the buyers compared to futures. But the seller of the option has the obligation to deliver the assets if the buyer chooses to exercise the option.

In case of options, the pre-decided price for the exchange of asset is called the Strike Price.

One thing to remember though is that in reality, not many people actually exercise their options – people do not actually exchange the asset at the time of exercise. Since the options are traded in the market, instead of exercising them, the buyers just sell them in the market.

The logic behind this – when an option is in the money (that is, when it becomes profitable for the buyer), its option premium or the price goes up. So, one can sell it and make profit instead of exercising it. This is easier, and therefore is done by most people.

American and European Options: The options are of two types – American and European. In American options, the option can be exercised any time upto the settlement date. In European options, the option can be exercised only on the settlement date. Thus, American options are much more flexible (I am introducing this here just as a concept – in India, only American options are traded).

Cost: There is a cost involved for options – the buyer of the option has to pay the seller an Option Premium, which is the fee the option seller (also called the Option Writer) gets in return for the one-sided guarantee he extends to the buyer. Since the option writer assumes the risk of the price movement, this fee is well justified.

Example: A writes the option of Reliance Industries stock to B. Quantity is 200 shares, strike price is Rs. 3200 and the expiry date is 3 months away. The option premium is Rs. 25.

Now, during these 3 months, say the price of Reliance Industries stock goes up to Rs. 3400. In this case, B would exercise the option, and would get the shares at Rs. 3200 from A.

Thus, B would make a profit of Rs. 3400 – Rs. 3200 – Rs. 25 (Option premium) = Rs. 175. Similarly, A would make a loss of Rs. 175.

But if the price of Reliance Industries stock remains less than Rs. 3200 for the 3 month duration, B would not exercise the option. In this case, the option buyer B would make a loss equal to the option premium – Rs. 25 in this case, and the option writer would make a profit equal to the option premium – Rs. 25.

Use of Derivatives

The primary use of a derivative is to hedge risk (also called Hedging). When you buy a derivative, you are making a provision that makes your cash flows more certain, or that limits your losses. (I would write another article to illustrate this using calculations).

For example, say you are an exporter, and your earnings are in dollars. Now, you would receive your payment of $15000 after six months. But since you spend in Rupees, you would also like to keep track of your earnings in Rupees.

The value of dollars after six months would decide your actual earning in rupees. Since that is not known right now, it brings uncertainty to your earnings too. Derivatives can be helpful in such a scenario.

You can buy Dollar – Rupee futures contract of $15000 with the rate of Rs. 39.5 for a dollar, and with a validity of 6 months. Thus, you would be certain about your earnings after 6 months – whether the rate after 6 months is Rs. 37 or Rs. 41, you would get Rs. 39.5 for every dollar.

For a business, this kind of certainty in cash flows and earnings can be a very big relief!

Hedging is the primary use of derivatives. But in the market, apart from hedgers, we also have many participants that use derivatives just for investments – people who want to make profits out of the price movement of derivatives – just like stocks.

The presence of such participants is not bad, because they provide liquidity and depth to the derivatives market.

Do come back to read articles describing derivatives in more detail….

Other articles you might be interested in:

• Mutual Funds - Growth or Dividend option?
• Life after life - Why you should buy Life Insurance
• "Settle" early in life - buy a home when young
• Interpreting Price to Earnings (PE) Ratio
• What is Price to Earnings (PE) ratio?
• Stocks - The winning bet for the long term
• What is Compound Annual Growth Rate (CAGR)?
• One size doesn't fit all
• Have you "invested" in jewellery?
• ELSS is not for someone else

Related links from the web (Sponsored):

Articles by Category:

• Gold
• Income Tax - IT
• Insurance
• Investment Philosophy and Planning
• Loans
• Mutual Funds
• News / Developments
• Others / Miscellaneous
• Real Estate
• Stocks / Shares / Equities

Note: Please treat the opinion expressed here as a broad suggestion. Please consult your financial planner / investment advisor before making any investment decision.