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Saturday, 05 December 2015 11:28

Options trading

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What is Options

It is a 
derivative security used for the purpose of risk management in the investment market, based on some security. Futures, forwards, swaps, options etc., are all examples of hedge against risk. Investors are risk averse and want to reduce the risk. Individuals and corporations have a strong urge to reduce or manage risk and this is secured by trading in derivative markets.

The volatility in share prices require to be hedge. Thus, the larger the volatility the larger is the hedging demand. This is secured through the options and futures. Thus the volume of futures or options can cause higher or lower volatility in underlying share/securities. These are all tools for risk management and no correlation is empirically found for options to increase or reduce volatility of shares prices

Characteristics of Options

Derivatives have many distinctive characteristics.

1. Their origin is from some other security, commodity or reference point, (such as indexes.)
2. They are instruments of hedge against risk of undue volatility.
3.They are leveraged instruments for risk management based on original security or instrument.

Calls and puts

The two major type of stock options are calls and puts. A call gives the investors the right to purchase 
100 shares of a particular stock at a fixed price until a specific date. An investor who purchases a call option locks in a price on 100 shares of stock for a predetermined time. A put option gives an investor the right to sell 100 shares of a particular stock at a fixed price until a specific date. A put in a price at which to sell stock rather than a price at which to buy stock. Both puts and c alls provide the investor with the right, but not the obligation, to use the option. Stock options are created, or written, by other investors who wish to earn income from selling the options. The writers then become obligated to sell (if a call has been sold) or purchase (if a put has been sold) the stock if and when the owner of the option decides to exercise the put or call.

Puts and calls derive their values from the values of the stock that they can be used to sell or purchase. Stock options pay no dividends or interest and expire without any value if not used by the expiration date. The value of call option is directly related to the value of the underlying stock(i.e. the option value increase when the stock value increase) and the value of a put is inversely related to the value of the underlying stock (i.e., the option value increase when the stock value decrease ). Option values are also affected by the time remaining until expiration, the price volatility of the underlying common stock and the market rate of interest.

Types of Derivatives

The security or 
asset classes on which the derivatives depend are :

(1) Debt or Bonds, (2) Equities ,(3) Indexes, (4) Commodities, (5) Currencies.

Options vs. Badla 

The age old method of badla financing facilities the carry forward transactions in the stock market and serves almost the same purpose of helping speculation and imparting greater volume and better liquidity , as in the case of options. In both methods, no delivery of securities is envisaged and both depend on some underlying securities traded on cash/delivery basis. Then why do SEBI and other influential sources advocate the substitution of badla by options in India? Their perception is that badla adds to spec ulation and it is better to separate the speculative market from real investment market, so that genuine investors are protected from the effect of excessive speculation. Options would have the same effects and objectives as badla trading. Both increase liquidity, cater to the instinct of speculation and provide a hedge against risk. Both are tools of risk management and based on some rules and regulations, margins and other terms.

The differences between them and the advantages of options over Badla may be set out as follows:

The risk can be limited and kept with in a range both in upward and downward direction in the case of options. Transparency in operations is possible due to well organized trading in contrasts in options. No manoeurvrability of terms, margins, expiration dates and no flexibility in operations are possible. Cash outlay is limited to the premiums paid and risk taken can be kept in limits. But once the contract period is over the right to nexercise option ceases and no advantage can be taken of any favourable change in price. But in the case of badla, money lending is used as a tool. There is flexibility of margin fixation, and in fixation of carry forward prices. Badla terms can be bargained and the trader has the chance to adjust his purchase and sale position depending on the price movements after settlement, which is not possible for the option purchaser once the contract period is over.

Thus, options and badla have both 
advantages and disadvantages. The edge of options over badla will come in due to electronic trading possible through the use of computer network and this will also ensure greater transparency to trading in options. Otherwisw the time tested method of badla is by itself not inferior as a method of facilitating speculative trading and to increase the volume of trade and liquidity in the securities markets.

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