Consider a situation when we analyse a particular script to be undervalued and expect its price to go up in the near future. We have the following alternatives with us:
- Buy the script in the cash market (spot market)
- Buy the futures contract on that script
- Buy Call Option
- Sell Put Option
Let us analyse each situation
If we buy in the spot market; we will have to invest the entire amount: price of stock multiplied by number of stocks. And then keep those securities with us till maturity. If the price of the script increases after a month or two and reaches our target price, we can sell it off and enjoy our profits.
If we buy the futures contract on that script, we’ll have to invest in one lot of that script and on maturity (2 or 3 months – as per the contract we bought, we make a profit or loss)
If we buy call option, we only have to shell out the premium amount right now. And we wait for 3 months (if we have bought the 3 months option), and on maturity date (European Style option), we compare the strike price with the spot price and either we exercise the option if it is profitable. Or we let out option contract expire as it does not make sense to exercise the option contract.
In other words, if the price of the underlying security is lower in the spot market, we would not want to exercise our call option and buy at higher price (strike price). But if the strike price is lower than the price of the script in the spot market, we will exercise our call option and make a profit. This is a high leveraged profit as we have only invested the premium amount and not the entire value of the scripts multiplied by the number of stocks. Our investment if very low as compared to the profits we will fetch if the option is in the money at expiration date.
And finally, if we have sold put options, we have enjoyed upfront premium, but we have a high risk position – as our profits are limited to the premium we have enjoyed, but our downfall can be unlimited as the price of the stock can move against our bet upto any extent. And as we have sold the option, we have the obligation to honor the option and the other person have the right to sell to us if the price of the stock in the spot market is less than the strike price of our contract.