Let`s take the case of Mr. Srinivasan as discussed in the article Part VII – Getting Started With Trading – How to Trade Options?

For those who are new to Options, Please visit the above article to get a glimpse and understanding of the different aspects of Options Trading.

Suppose, Mr. Srinivisan wants to buy a house (asset) for Rs. 50 Lacs (Fixed Price) from Mr. Sachin who asks him to pay a privilege or premium amount of Rs. 1 Lac (Premium) to extend a time period of 3 month (Expiration Date) to pay him. Then Srinivasan (Buyer of the house) had the choice to either buy the house or let the agreement expires but Sachin (Seller of the house) has an obligation to sell the house, if Mr. Srinivasan chooses to buy the house, on or before the expiration time (i.e. 3 months).

Suppose, if at the end or before three month expiration, the price of the property rises and Srinivasan is able to find a buyer for that house for any price more than the agreed amount, say 60 Lacs, then he exercise his option to buy the house for Rs. 50 Lacs and make a profit of 9 Lacs (60 – 50 -1).
But on the other hand, if Srinivasan is unable to find a buyer for that house for more than 50 Lacs, then he loses 1 Lacs premium and he do not need to buy that house and let his right to buy expires.

In the example above, Mr. Srinivasan is the Buyer of the Call Option where as Mr. Sachin is the Seller of the Call Option.
So, as the buyer of the Call Option, Mr. Srinivasan has the right (but not the obligation) to buy the house (Strike Price – 50 Lacs) for which he paid a premium of Rs. 1 Lacs. So his loss is limited to the premium price he paid to extend him a time period of three months for the house while his profits are unlimited depending on the price he is able to get another buyer to pay for the house within these three months.
But on the other hand, Mr. Sachin who is the seller of Call Option has the obligation to sell the house (Strike Price – 50 Lacs), if Mr. Srinivasan chooses to buy the house within three months, for which he received a premium of Rs. 1 lacs. So, his profit is limited to the premium he received while his losses are unlimited as the price of the house can rise to any price within these three months.

 

From the above, we can now outline the rights and obligations of the Option Buyers or Option Sellers.

 

Option Buying & Selling

If you buy an option (Call or Put), you have the right to buy/sell the underlying instrument at the strike price on or before expiration. The situation is different if you sell or write an option. Selling an option obligates the writer to fulfill their side of the contract if the option holder wishes to exercise.
However in real market, just as the buyer can sell an option back into the market rather than exercising it, a writer can offset the options contract by purchasing an option to close the transaction and end their obligation.

 

The list below illustrates the rights and obligations of the Call Buyers & Sellers.

Call Buyers Call Sellers
Have right to buy the underlying Have an obligation to sell, if assigned
Pays premium Collects premium
No Margin requirement Incur Margin Requirement
Loss is limited to premium paid Loss could be unlimited
Profits can be unlimited Profits are limited to premium received
Time decay works against them Time decay works in their favor

The list below illustrates the rights and obligations of the Put Buyers & Sellers.

Put Buyers Put Sellers
Have right to sell the underlying Have an obligation to buy, if assigned
Pays premium Collects premium
No Margin requirement Incur Margin Requirement
Loss is limited to premium paid Loss could be unlimited
Profits can be unlimited Profits are limited to premium received
Time decay works against them Time decay works in their favor

Now, we can illustrate the similar example in Case of Nifty Options as same applies with Options on index or stocks.

Mr. Srinivisan wishes to buy the Nifty Index (Asset) when it is trading at the level of 7000 (Fixed Price). He buys a Nifty 7000 Call Option (Strike Price) for Rs. 50 (Premium) with an expiration of one month. Then Srinivasan (Buyer of the Nifty Call Option) had the choice to either buy the Nifty or let the agreement expires but the Seller of the Call Options (say Mr. Sachin) had an obligation to sell Nifty at 7000, if Mr. Srinivasan chooses to buy the Nifty, on or before the expiration time (i.e. 1 months).

In the example above, Mr. Srinivasan is the Buyer of the Call Option where as Mr. Sachin is the Seller of the Call Option.

 

For the Buyer of the Call Options – Mr. Srinivasan

As the buyer of the Call Option, Mr. Srinivasan has the right (but not the obligation) to buy the Nifty (Strike Price – 7000) for which he paid a premium of Rs. 50. So his loss is limited to the premium price he paid to extend him a time period of one months while his profits are unlimited depending on the price of the Nifty within one month.

Suppose, if at the end or before one month expiration, Nifty rises to 7200, then he exercise his option to buy the Nifty for 7000 and make a profit of Rs. 150 (7200 – 7000 -50).
But on the other hand, if at the end or before one month expiration, Nifty declines to 6800 then he do not need to buy the Nifty at 7000 and let his right to buy expires and suffers a maximum loss of Rs. 50.

 

For the Seller of the Call Option – Mr. Sachin
Mr. Sachin who is the seller of Call Option has the obligation to sell the Nifty (Strike Price – 7000), if Mr. Srinivasan chooses to buy the Nifty within one month, for which he received a premium of Rs. 50. So, his profit is limited to the premium he received while his losses are unlimited as the price of the Nifty can rise to any price within one month.

Suppose, if at the end or before one month expiration, Nifty rises to 7200, then Mr. Srinivasan will exercise his option to buy the Nifty for 7000. So, Sachin will bear a loss of Rs. 150 (7200 – 7000 -50).

But on the other hand, if at the end or before one month expiration, Nifty declines to 6800 then Mr. Srinivasan will let his right to buy expires. So, Sachin will keep the premium and will have the profit of Rs. 50.

 

From the above illustration, we can conclude that the seller of the options contract is under obligation to exercise the agreement as his losses can be unlimited if the underlying asset price rises in case of Call Options or falls in case of put options.
So, he is under obligation to pay a margin just like in case of futures contract.

While, the buyers of the options contract has a right to exercise his agreement or let the contract expires. So, there losses are limited to the premium they pay while his profits are unlimited if the underlying asset rises in case of Call Options or falls in case of put options.
So, they are obligated to pay only the premium amount required to buy the right of the asset.
KNOWLEDGE IS POWER!

 

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Why More Margin is Required to Short / Write Options than Buying Options?

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