Definition of Terms
Term
OPTIONS
raagvamd, RaagVamdatt |
This is a type of derivative. It is a contract through which the buyer of the option gets the right to buy / sell a pre-specified quantity of the underlying at a pre-specified price and a pre-specified date.
The option buyer has the right but not the obligation to exercise the option. This means that if the market price of the underlying is favourable, the investor would exercise the option, otherwise he would not.
The option seller also called the writer of the option, however, is obligated to go with the buyer's choice.
An option buyer has to pay an option premium to the option writer at the time of entering into an options agreement.
Example:
On 1st November 2007, an investor enters into a futures contract to buy 1000 shares of Reliance Indutries at Rs. 2000 per share on 31st December 2007.
If, on 31st December 2007, the market price of Reliance Industries is more than Rs. 2000, the buyer of the option would exercise the option, so that he can buy at Rs. 2000 and sell at the market price to make a profit.
But if , on 31st December 2007, the market price of Reliance Indutries is less than Rs. 2000, the buyer of the option would not exercise the option, and would allow it to lapse. The loss to the buyer of the option would be limited to the option premium paid by him.
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