Options are derivative contract which slice up the rights and obligations in a futures contract. The buyer of an option has the right to buy (in case of “call”) or sell (in case of “put”) an underlying on a specific date, at a specific price, on a future date. The seller of an option is under the obligation to exercise the option but is not under the obligation.
A buyer of an option has the right to buy the option and the seller has the right to sell the option. When the buyer exercises the option the seller of the call option has to complete the delivery as per the terms agreed. For granting this right to the buyer, the seller collects a small upfront payment, called the option premium, when he sells the option.
BUY/SELL A CALL OPTION
This gives the buyer of the option the right to buy a security on a specified date in future at the specified price, also known as the strike price. The buyer of the option pays a premium to the seller of option (also known as writer). The buyer of the option exercises his right if on the specified date the strike price is lower than the market price (spot price) of the security.
Assume that a trader buys one call option of XYZ company trading at a strike price of Rs 100. Remember, a stock option contract is the option to buy 100 shares. He pays Rs 300 as option premium. Now if the stock is trading above Rs100 the buyer of the stock will exercise the right to buy the stock at Rs100. The seller has to sell the stocks at price of Rs 100 even if the market price is higher. Now the buyer sells the stock at Rs120 in the market. The buyer paid Rs 10000(100*100) for the shares and sell the shares at Rs 12000. The buyer made a net profit of Rs 1700 (2000- 300).
BUY/SELL A PUT OPTION
The put buyer has the right to sell a security at the set amount of time at a specified price. For that right, the put buyer pays a premium. If the price of the underlying moves below the strike price, the option will be worth money (will have intrinsic value). The buyer can sell the option for a profit (what most put buyers do) or exercise the option at expiry (sell the shares).