Derivative and Option Contract

The term "Derivative" indicates that it has no independent value, i.e. it's value is entirely derived from the value of the underlying assets. The underlying asset can be Securities, Commodities, Bullion's, Currency, Livestock or anything else. It is a legally enforceable, written document on which different types of instruments are written-

There are four major type of Derivative contracts-

Let us discuss about Option Contract in this feed-

Option is a derivative instrument in which buyer of option gets a right and seller of option are under obligation. Option buyer need to pay "Option Premium" to option seller at the time of purchasing option. An Option has no value itself, but it's value will be based on some underlying assets.

There are three type of Duration in an Option Contract-

1. Near Month - 1 Month Expiry
2. Middle Month - 2 Months Expiry
3. Far Months - 3 Months Expiry

There are two types of Options -

1.  Call Option - Right to Buy
1. Buyer of Call option is having a "Right to Buy" an underline asset at a given price. Call option is purchased when price of underlying asset seems to show a upside move in future. 
2. For instance, Mr. A paid Rs. 20 as call option premium and entered into a contact to buy a lot of 20 shares of Reliance Industry at a price of Rs. 1200 with a validity of 30 days. Let say, after expiry of 30 days, Share price of Reliance Industry goes up to Rs. 1250. Here, Mr. A has right to buy the same share at Rs. 1200 which has market value of Rs. 1250 and therefore Mr. A have a profit of Rs. 600 (Profit of Rs. 50 {Rs. 1250 - Rs. 1200} - Call Option Premium of Rs. 20 = Net Profit of Rs. 30 * Lot Size 20). 
3. If share price of Reliance Industry fall below Rs. 1220 then Mr. would be in loss accordingly. Break Even Point (BEP) for Mr. A in this contract is Rs. 1220, any price above Rs. 1220 is profit and below is loss.

1. Put Option - Right to Sell
1. Buyer of Put option is having a "Right to Sell" an underline asset at a given price. Put option is purchased when price of underlying asset seems to show a downside move in future. 
2. For instance, Mr. A paid Rs. 20 as Put option premium and entered into a contact to sell a lot of 20 shares of Reliance Industry at a price of Rs. 1200 with a validity of 30 days. Let say, after expiry of 30 days, Share price of Reliance Industry goes down to Rs. 1140. Here, Mr. A has right to sell the same share at Rs. 1200 which has market value of Rs. 1140 and therefore Mr. A have a profit of Rs. 800 (Profit of Rs. 60 {Rs. 1200 - Rs. 1140} - Put Option Premium of Rs. 20 = Net Profit of Rs. 40 * Lot Size 20).
3.  If share price of Reliance Industry goes above Rs. 1180 then Mr. would be in loss accordingly. Break Even Point (BEP) for Mr. A in this contract is Rs. 1180, any price below Rs. 1180 is profit and above is loss.

Here are some important aspects related to Derivative instruments and Option Trading-

1. Value of an Option can never be zero because it is an asset.
2. Option Premium is the amount charged by option seller from option buyer at the time of selling of option.
3. Option is always sale with it predetermined exercise price.
4. Underlying Assets may be Stock or Index (SENSEX/NIFTY) or any thing whose value is variable.

There are many more concepts in the option trading like, calculation of Option Premium, Calculation of Value of Option using different methods, Earning Arbitrager Gain which is risk free profit, different approaches and strategies to hedge the portfolio. We will cover these remaining part in upcoming feeds, till then Learn, Grow and Stay Safe.

Happy Learning !!!