What are Options... continued

Continuing with the example in the previous post, before we understand what makes this whole transaction resemble to 'Option' let us try our hands at ethics (I am an ethical trader, don't forget) and see if any one party is being short-handed here.

The farmer, by agreeing to price of Rs 2000 after two months has the thinking that though the rate may be higher after two months, they could be lower as well. Expecting higher prices, lot of farmers may grow sugar cane and supply may increase bringing down the prices. He has ensured his peace of mind by securing a price which he thinks is reasonable for him.

Similarly for you, you are of the thinking that you can sell it at a higher price and hence you are entering in this transaction. There is risk for you but hey aren't you a trader...

So that settles it. It is totally ethical and hence I can get in to it (I can be such a jerk at times).

Now what exactly is ‘Option’ in this?

Simple, by paying 100 Rs, you have ‘bought’ a ‘right’ to purchase the sugar cane crop at an agreed price in the future. This ‘right’ is called as an ‘option’. The ‘fee’ of 100 Rs is called as ‘premium’

Good to note that, you are a (option) buyer here (thank God they kept the terminology simple here). However the seller, the farmer, is not called a seller… he is bestowed with a fancy name of ‘Option Writer’.

Before I close, the last thing worth mentioning is, you as a buyer, have the ‘right’ to purchase sugar cane. In case after two month, you don’t want to, you will simply walk away losing 100 Rs (premium or fee that you paid). However, the farmer cannot walk away in this case. He (seller or writer) has to honor his side if buyer is asking for it. This ‘asking’… buyer asking for completing the transaction is called ‘exercising’ the option. So much for the fancy names… But this is one fancy name I like.

After all, ‘exercising’ is one thing; you should do every day, particularly a sofa potato like me. Off I go to get some ‘exercise’.