Explanation of Option Contract with a simple example08/09/2022 0 By indiafreenotes
An option contract is an agreement that gives the option holder the right to buy or sell the underlying asset at a certain date (known as expiration date or maturity date) at a prespecified price (known as strike price or exercise price) whereas the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.
There are 2 Parties to the Contract
- Option Holder or Buyer of the Option: It pays the initial cost to enter into the agreement. The call option buyer benefits from price increase but has limited downside risk in the event price decreases because at most he can lose is the option premium. Similarly, the put option buyer benefits from price decrease but has limited downside risk in the event when price increases. In short, they limit the investor’s downside exposure while keeping the upside potential unlimited.
- Option Seller or Writer of the Option: It receives the premium at the initiation of the option contract to bear the risk. The call writer benefits from Price decrease but has unlimited upside risk in case price increases. Similarly put writer benefits if price increases as he will keep the premium but may lose a considerable amount of price decrease.
It gives the owner the right to buy an underlying asset at a strike price at the expiration date. The call owner is bullish (expects the stock price to rise) on the movement of the underlying assets. Let’s take an example Consider an investor who buys the call option with a strike of $7820. The current price is $7600, the expiration date is in 4 months and the price of the option to purchase one share is $50.
Long Call Payoff Per-Share = [MAX (Stock Price – Strike Price,0) – Upfront Premium Per Share
- Case 1: if the stock price at expiration is $7920 the option will be exercised and the holder will buy it @ $7820 and sell it immediately in the market for $7920 realizing a gain of $100 considering upfront premium paid of $50, the net profit is $50.
- Case 2: if the stock price at expiration is $7700 the option holder will choose not to exercise as there is no point in buying it at $7820 when the market price of the stock is $7700. Considering the upfront premium of $50, the net loss is $50.
It gives the owner the right to sell an underlying asset ta strike price at the expiration date. The put owner is bearish (expects the stock price to fall) on the movement of the stock price. Let’s take an example Consider an investor who buys the put option with a strike of $7550. The current price is $7600, the expiration date is in 3 months and the price of the option to purchase one share is $50.
Long Put Payoff Per-Share = [MAX (Strike Price – Stock Price, 0) – Upfront premium Per Share
- Case 1: if the stock price at expiration is $7300 the investor will buy the asset in the market at $7300 and sell it under the terms of put option @7550 to realize a gain of $250. Considering the upfront premium paid $50 the net profit is $200.
- Case 2: if the stock price at expiration is $7700 the put option expires worthless and the investor loses $50 which is the upfront premium.