WHAT IS OPTIONS ?
 

Around 1982, the Options first made their appearance at the CBOT in Chicago. These were modified products of the indices and stocks and therefore yet another derivative product. Once again, the idea was to reduce or shift the risk from the holder of the goods to those who are willing to take it up.
 

We saw in the case of the Futures that the buyers and sellers were clear about what they wanted to do. There would be occasions when traders may not be too sure of the future direction of prices. Hence they may like to trade with an assurance that if their view did not fructify, there would not be a need to perform on the obligation of a future purchase or a sale deal struck today. For such an assurance, they do need to find someone who can take up the other side of this deal. This someone would be a person who would hold an opposite view – that the market or stock would not perform in the manner as conceived by the other party.
 
For example, if a person feels that the market is likely to move up over the next few months but is not too sure, he would like to find a seller of index who would not demand performance (that is enforce delivery) if the market failed to move up. So, what the buyer is actually looking for is a one sided contract where the right to buy rests with him but not the obligation to perform on the purchased right! Incredibly, such an instrument does exist in the markets and is known as an Option contract.
 
Options are therefore defined as a right to buy or sell an underlying asset (in our case a stock or an index) at a future date and price without the accompanying obligation.
 
In effect, what the buyer of such an instrument is doing is buying insurance. It is insurance against his view being wrong! Naturally, such instruments will carry with them some kind of costs. We all know that insurance is a one-way street. We keep paying so that the event we fear will not occur. Life insurance covers one in the event of death. We keep paying the premium to stay alive, so to speak. In a similar fashion, therefore, options on stocks and indices carry with them a cost, known as the Premium, which needs to be paid by the buyer.
 
Purchase of an option therefore, confers the buyer with a right to either buy the underlying asset from the seller at a future date or sell the asset to him, at a price agreed upon today. For this right, the buyer pays the seller some premium upfront. In case the prices do not move as the buyer of the option expects, he would simply forget about the whole thing. This is known as allowing the option to expire worthless or unexercised.
 
We have stated earlier that Options give us the right to either buy or sell the underlying (stock or index) at a fixed price and fixed time. To differentiate the transaction, the right to buy is named a Call while the right to sell is named a Put. Therefore trading in options means trading in calls and puts. One can either buy calls and puts or one can sell them. The buyer has the right without the obligation while the seller has the obligation to deliver to the buyer if the latter chooses to exercise his right. For this right, the buyer pays a premium that is received by the seller. The exercise of the right can be of two types. The first, called the European option allows the buyer to exercise his right only the day of expiration while the second, called the American option, allows the buyer to exercise his right anytime after purchase. Currently, we trade the European model for Index options while stocks options are traded under the American model.