Let’s say there’s a farmer who cultivates wheat and there is a baker who needs wheat as an input for making bread.
The farmer thinks that the price of wheat which is currently trading at Rs.100/- could fall to Rs.90/- in 3 months. The baker on the other hand feels that the price of wheat on the other hand might become Rs.120/- in 3 months. In such a case both of them get together and sign a contract which says that at the end of 3 months the farmer would sell wheat to the baker at Rs.110/-. Thus, the farmer is protected against possible fall in prices. And the baker is protected against the price of wheat going beyond Rs.110/-. Such a contract is called a Futures contract. In a Futures contract both parties are obliged to honor the contract and there is no escape route for either party.
But what if the contract gives the farmer the “option” of either Selling his produce to the baker at the pre agreed price of Rs.110/- or choosing to exit the contract and selling the produce in the open market or wherever he deems fit. Thus, he would not be obliged to honor the contract made with the baker on the date of settlement. Such a contract which gives the farmer the option of either executing the contract or exiting it is known as an “Options” contract. But the farmer obviously cannot get this privilege just like that. He obviously has to pay a premium for exercising this facility.
Now, let’s say that after 3 months the price of wheat reaches Rs.120/-. In this case the farmer quite obviously will want to exit the contract so that he is free to sell his produce in the open market for Rs.120/-. Thus, while the farmer gets away the baker is left high and dry and has no other option but to buy from the open market at Rs.120/-.
But it is not such a bad situation for the baker as it appears as he gets compensated by the farmer for having been a party to the “Options” contract. This compensation in the form of price is called the “Option premium” that the farmer has to pay for the Options contract and quite evidently it would be a small amount.
Let’s say in our case the amount is Rs.2/-. So, the farmer is obliged to pay the baker Rs.2/- as he has chosen to opt out of the contract. Thus, although the baker has no other option left but to go to the open market and purchase wheat at Rs.120/-, he does get the benefit of Rs.2/- as compensation for being a party to the Options contract. So even if the price is Rs. 120 in the open market, for him the effective price turns out to be Rs.120 – Rs.2 = Rs.118/-.
So, by simply participating in the contract he too stands to gain something. As far as the farmer is concerned it is a win – win scenario for him by participating in the contract.
Had the prices fallen to Rs.90/- as he had anticipated he would have executed the Options contract. But since prices rose to Rs.120/- he chose to exit the contract. Thus, he is blessed with the Option by signing such a contract. It is important to understand that in an Options contract only one party gets the privilege to exercise the option while the other party is obliged to honor the option chosen. Thus, in our case the farmer has the option to either execute or exit the contract whereas the baker is obliged to honor the decision of the farmer.
A contract such as this where only the seller of the commodity gets the option to either exercise or exit the contract is known as “Put” option.
There is another option which is called a “Call” option.
Even in an Options contract both parties land up achieving their goals and their interest is protected.
- The farmer stands to gain the most by getting to exercise a choice that benefits him the most.
- The baker too benefits by being a party to the contract due to the compensation he receives from the farmer for not honoring the contract.
- The baker due to the compensation receives wheat from the open market at an effective price of Rs.118/-
- And hence is better off than the ordinary or spot buyer who would have to pay Rs.120/-.
Thus, in a sense both parties landed up getting some gains by being parties to the “options contract”.
However, unlike in a “Futures” contract, in the “Options” contract one party gains more than the other party.
Takeaways,
- Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed upon price and date.
- Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation.
- Options are versatile financial products. These contracts involve a buyer and seller, where the buyer pays a premium for the rights granted by the contract.
- Call options allow the holder to buy the asset at a stated price within a specific timeframe.
- Put options, on the other hand, allow the holder to sell the asset at a stated price within a specific timeframe.
- Each call option has a bullish buyer and a bearish seller while put options have a bearish buyer and a bullish seller.
