Understanding OPTIONS

About Stock Options
Stock options today are hailed as one of the most successful financial products to be introduced in modern times. Options have proven to be superior and prudent investment tools offering you, the investor, flexibility, diversification and control in protecting your stock portfolio or in generating additional investment income.
Options are financial instruments that can be used effectively under almost every market condition and for almost every investment goal. Among a few of many ways, options can help you:
Protect your stock holdings against a decline in market prices

Increase your income on current or new stock holdings

Buy stock at a lower price

Benefit from a stock price’s rise or fall without owing the stock or selling it outright.

What is an Option?
An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price on or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract. For illustrative purposes the term shares is used throughout this booklet when referring to the underlying securities. When considering options over an index, the same concepts generally apply. From time to time options may be available over other types of securities such as instalment receipts or preference shares.
The standard number of shares covered by one option contract vary from stock to Stock.

There are two types of options available: call options and put options.
Call options
Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date.
Call option example
Assume RIL shares have a last sale price of Rs.556. An available standard call option contract would be an RIL August Rs.525. A taker of this contract has the right, but not the obligation, to buy 600 RIL shares (1 contract is equal to 600 shares in case of RIL shares) for Rs.525 per share at any time until the expiry day in August (normally last Thursday of every month). For this right, the taker pays a premium (or purchase price) to the writer of the option. In order to take up this right to buy the RIL shares at the specified price, the taker must exercise the option on or before the expiry day in August. On the other hand, the writer of this call option is obliged to deliver 600 RIL shares at Rs.525 per share if the taker exercises the option. For accepting this obligation the writer receives and keeps the option premium whether the option is exercised or not.

To be continued...