Transfer Pricing Law In India
Increasing participation of multi-national groups in economic activities in the country has given rise to new and complex issues emerging from transactions entered into between two or more enterprises belonging to the same multi-national group. With a view to provide a detailed statutory framework which can lead to computation of reasonable, fair and equitable profits and tax in India, in the case of such multinational enterprises, the Finance Act, 2001 substituted section 92 with a new section and introduced new sections 92A to 92F in the Income-tax Act, relating to computation of income from an international transaction having regard to the arm's length price, meaning of associated enterprise, meaning of information and documents by persons entering into international transactions and definitions of certain expressions occurring in the said section.Section 92: As substituted by the Finance Act, 2002 provides that any income arising from an international transaction or where the international transaction comprise of only an outgoing, the allowance for such expenses or interest arising from the international transaction shall be determined having regard to the arm's length price. The provisions, however, would not be applicable in a case where the application of arm's length price results in decrease in the overall tax incidence in India in respect of the parties involved in the international transaction.Arm's length price: In accordance with internationally accepted principles, it has been provided that any income arising from an international transaction or an outgoing like expenses or interest from the international transaction between associated enterprises shall be computed having regard to the arm's length price, which is the price that would be charged in the transaction if it had been entered into by unrelated parties in similar conditions. The arm's length price shall be determined by one of the methods specified in Section 92C in the manner prescribed in Rules 10A to 10C that have been notified vide S.O. 808 E dated 21.8.2001.Specified methods are as follows:
a. Comparable uncontrolled price method;b. Resale price method;c. Cost plus method;d. Profit split method ore. Transactional net margin method.
The taxpayer can select the most appropriate method to be applied to any given transaction, but such selection has to be made taking into account the factors prescribed in the Rules. With a view to allow a degree of flexibility in adopting an arm's length price the proviso to sub-section (2) of section 92C provides that where the most appropriate method results in more than one price, a price which differs from the arithmetical mean by an amount not exceeding five percent of such mean may be taken to be the arm's length price, at the option of the assessee.
Associated Enterprises: Section 92A provides meaning of the expression associated enterprises. The enterprises will be taken to be associated enterprises if one enterprise is controlled by the other, or both enterprises are controlled by a common third person. The concept of control adopted in the legislation extends not only to control through holding shares or voting power or the power to appoint the management of an enterprise, but also through debt, blood relationships, and control over various components of the business activity performed by the taxpayer such as control over raw materials, sales and intangibles.
International Transaction: Section 92B provides a broad definition of an international transaction, which is to be read with the definition of transactions given in section 92F. An international transaction is essentially a cross border transaction between associated enterprises in any sort of property, whether tangible or intangible, or in the provision of services, lending of money etc. At least one of the parties to the transaction must be a non-resident. The definition also covers a transaction between two non-residents where for example, one of them has a permanent establishment whose income is taxable in India.
Sub-section (2), of section 92B extends the scope of the definition of international transaction by providing that a transaction entered into with an unrelated person shall be deemed to be a transaction with an associated enterprise, if there exists a prior agreement in relation to the transaction between such other person and the associated enterprise, or the terms of the relevant transaction are determined by the associated enterprise.
An illustration of such a transaction could be where the assessee, being an enterprise resident in India, exports goods to an unrelated person abroad, and there is a separate arrangement or agreement between the unrelated person and an associated enterprise which influences the price at which the goods are exported. In such a case the transaction with the unrelated enterprise will also be subject to transfer pricing regulations.
Documentation: Section 92D provides that every person who has undertaken an international taxation shall keep and maintain such information and documents as specified by rules made by the Board. The Board has also been empowered to specify by rules the period for which the information and documents are required to be retained. The documentation has been prescribed under Rule 10D. Such documentation includes background information on the commercial environment in which the transaction has been entered into, and information regarding the international transaction entered into, the analysis carried out to select the most appropriate method and to identify comparable transactions, and the actual working out of the arm's length price of the transaction. The documentation should be available with the assessee by the specified date defined in section 92F and should be retained for a period of 8 years. During the course of any proceedings under the Act, an AO or Commissioner (Appeals) may require any person who has undertaken an international transaction to furnish any of the information and documents specified under the rule within a period of thirty days from the date of receipt of notice issued in this regard, and such period may be extended by a further period not exceeding thirty days.
Further, Section 92E provides that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish such report on or before the specified date in the prescribed form and manner. Rule 10E and form No. 3CEB have been notified in this regard. The accountants report only requires furnishing of factual information relating to the international transaction entered into, the arm' s length price determined by the assessee and the method applied in such determination. It also requires an opinion as to whether the prescribed documentation has been maintained.
Burden of Proof: The primary onus is on the taxpayer to determine an arm's length price in accordance with the rules, and to substantiate the same with the prescribed documentation: where such onus is discharged by the assessee and the data used for determining the arm's length price is reliable and correct there can be no intervention by the Assessing Officer (AO). This is made clear in sub-section (3) of section 92C which provides that the AO may intervene only if he is, on the basis of material or information or document in his possession of the opinion that the price charged in the international transaction has not been determined in accordance with the methods prescribed, or information and documents relating to the international transaction have not been kept and maintained by the assessee in accordance with the provisions of section 92D and the rules made there under, or the information or data used in computation of the arm's length price is not reliable or correct ; or the assessee has failed to furnish, within the specified time; any information or document which he was required to furnish by a notice issued under sub-section (3) of section 92D. If any one of such circumstances exists, the AO may reject the price adopted by the assessee and determine the arm's length price in accordance with the same rules. However, an opportunity has to be given to the assessee before determining such price. Thereafter, the AO may compute the total income on the basis of the arm's length price so determined by him under sub-section (4) of section 92C.
Section 92CA provides that where an assessee has entered into an international transaction in any previous year, the AO may, with the prior approval of the Commissioner, refer the computation of arm's length price in relation to the said international transaction to a Transfer Pricing Officer. The Transfer Pricing Officer, after giving the assessee an opportunity of being heard and after making enquiries, shall determine the arm's length price in relation to the international transaction in accordance with sub-section (3) of section 92C. The AO shall then compute the total income of the assessee under sub-section (4) of section 92C having regard to the arm's length price determined by the Transfer Pricing Officer.
The Transfer Pricing Officer means a Joint Commissioner/Deputy Commissioner/Assistant Commissioner authorized by the Board to perform functions of an AO specified in section 92C & 92D.
The first proviso to section 92 C(4) recognizes the commercial reality that even when a transfer pricing adjustment is made under that sub-section the amount represented by the adjustment would not actually have been received in India or would have actually gone out of the country. Therefore no deductions u/s 10A or 10B or under chapter VI-A shall be allowed in respect of the amount of adjustment.
The second proviso to section 92C(4) provides that where the total income of an enterprise is computed by the AO on the basis of the arm's length price as computed by him, the income of the other associated enterprise shall not be recomputed by reason of such determination of arm's length price in the case of the first mentioned enterprise, where the tax has been deducted or such tax was deductible, even if not actually deducted under the provision of chapter VIIB on the amount paid by the first enterprise to the other associate enterprise.
Penalties: Penalties have been provided as a disincentive for non-compliance with procedural requirements. Explanation 7 to sub-section (1) of section 271 provides that where in the case of an assessee who has entered into an international transaction any amount is added or disallowed in computing the total income under sub-sections (1) and (2) of section 92, then, the amount so added or disallowed shall be deemed to represent income in respect of which particulars have been concealed or inaccurate particulars have been furnished. However, no penalty under this provision can be levied where the assessee proves to the satisfaction of the Assessing Officer (AO) or the Commissioner of Income Tax (Appeals) that the price charged or paid in such transaction has been determined in accordance with section 92 in good faith and with due diligence.Section 271AA provides that if any person who has entered into an international transaction fails to keep and maintain any such information and documents as specified under section 92D, the AO or Commissioner of Income Tax (Appeals) may levy a penalty of a sum equal to 2% of the value of international transaction entered into by such person.Section 271BA provides that if any person fails to furnish a report from an accountant as required by section 92E, the AO may levy a penalty of a sum of one lakh rupees.Section 271G provides that if any person who has entered into an international transaction fails to furnish any information or documents as required under section 92D (3), the AO or CIT(A) may levy a penalty equal to 2% of the value of the international transaction.Above mentioned penalties shall not be imposable if the assessee proves that there was reasonable cause for such failures.
Some Important Definitions: Section 92F defines the expressions " accountant arm's length price", "enterprise", "permanent establishment", "specified date" and "transaction" used in section 92,92A, 92B, 92C,92D and 92E. The definition of enterprise is broad and includes a permanent establishment (PE) even though a PE is not a separate legal entity. Consequently, transaction between a foreign enterprise and its PE, for example between the head office abroad and a branch in India, are also subject to these transfer-pricing regulations. Also the regulations would apply to transactions between foreign enterprise and a PE of another foreign enterprise. The term PE has been defined on the lines of the definition found in tax treaties entered into by India with other countries. PE includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.
Wednesday, June 24, 2009
Sunday, January 4, 2009
Straddle and Strangle stretegy
What is Straddle?An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date.Why it should be used?An investor who is convinced a particular index will make a major directional move, but not sure whether up or down.An investor who anticipates increased volatility in an index, up and/or down around its current level, and a concurrent increase in overlying options’ implied volatility.An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk.Example :Let’s assume the price is currently at $15 and we are currently in April 05. Suppose the price of the $15 call option for June 05 has a price of $2. The price of the $15 put option for June 05 has a price of $1. A straddle is achieved by buying both the call and the put for a total of $300: ($2 + $1) x 100 = 300. The investor in this situation will gain if the stock moves higher (because of the long call option) or if the stock goes lower (because of the long put option). Profits will be realized as long as the price of the stock moves by more than $3 per share in either direction. A strangle is used when the investor believes the stock has a better chance of moving in a certain direction, but would still like to be protected in the case of a negative move. For example, let's say you believe the mining results will be positive, meaning you require less downside protection. Instead of buying the put option with the strike price of $15, maybe you should look at buying the $12.50 strike that has a price of $0.25. In this case, buying this put option will lower the cost of the strategy and will also require less of an upward move for you to break even. Using the put option in this strangle will still protect the extreme downside, while putting you, the investor, in a better position to gain from a positive announcement.Strangle An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy is profitable only if there are large movements in the price of the underlying asset. This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be. The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.
Option
The trading market for Option is so huge and exciting that it commands a dedicated article on itself.
Options
An option is a contract where the buyer has the “right” (depends on buyer to execute it), but not the “obligation” (legally bonded) to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. An option is a security, just like a stock or bond, and constitutes a binding legal contract with strictly defined terms and conditions.
Futures Vs Options
Remember from the previous article, Futures are contracts where both the buyer and the seller have the obligation to honor the contract whereas option does not involve any obligation for both the parties. A contract is a zero sum game i.e. one party will book loss while the other take home the profit. If the contract is futures, the losing party will pay the winning party. However, in options, the buyer will decide whether to execute the contract. You will understand this by the following example.
Let say there is a contract between you and me which says that I will buy one kg of gold at Rs. 1,000 per gm from you on March 1st, 2009. I am the buyer of this contract and you are the seller. So we will either go for cash settlement or you have to deliver the gold to me. Now suppose on the date of settlement i.e. March 1st, 2009, price of gold is Rs. 500 per gram. Thus, the market price of gold on March 1st, 2009 is lower than the contract price.
If the contract were Futures, I would have to buy the gold from you because I have the “obligation” to do so. Hence, I will pay you Rs. 1,000 per gm and you will deliver me the gold. Hence, you make profit while I book loss. Good for you, Bad for me!!
However, if the contract were an Option, I would not have executed it i.e. would not have bought the gold from you. I would have let the contract expire (i.e. do nothing and wait till March 1st, 2009 passes by). How can I do so? I can do it because Options gives me (the buyer) the “right” and not the “obligation” to buy it. Thus, an option would protect me from any adverse movement in the price of underlying asset. In an option, seller has no right because he is compensated by the buyer by paying option premium. Thus, the buyer of an option contract has the “right” but the seller of option contract has the “obligation” to honor the option.
So you may now be wondering that why on earth somebody will ever buy a futures contract when options contract are better. We must know that option has a “premium” attached to it which is called “Options Premium”. This is the amount that a buyer of option contract has to pay the seller of the option contract in exchange for higher flexibility and protection against adverse price movement in the value of underlying. Thus, if I have to buy an option contract from you, I will pay a premium to the seller i.e. You.
Options Vs Stocks
In order for you to better understand the benefits of trading options you must first understand some of the similarities and differences between options and stocks.
Similarities:
• Listed Options are securities, just like stocks.
• Options trade like stocks, with buyers making bids and sellers making offers.
• Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Differences:
• Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).
• Options have expiration dates, while stocks do not.
• There is not a fixed number of options, as there are with stocks available e.g. there could tens or even hundreds of options written on the same stock
• Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.
Remember these options are not issued or written by companies who stocks act as underlying asset. These options are generally written by brokers or traders for investors.
Options Terminology
Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the seller.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract from the seller. The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.
Classes of Options
There are two classes of options – American Option and European Option. The key differences are:
1. American option can be exercised before the expiration while an European option is exercised only on the expiration date.
2. Dividends can be issued by the underlying stock in an American option while it is not the case in European option
Types of Options
There are only two types of options: Call option and Put option. In this article we will discuss only European options i.e. options which can not be executed before the agreed upon date.
Call Options
A Call Option is an option to “buy” a stock (underlying) at a specific price on a certain date. The buyer of call option holds the rights while the seller has the obligation to honor the contract. The buyer of a call option enters the contract assuming that the value of underlying will increase in future and benefit him. The seller thinks otherwise i.e. the stock price will not go up and hence the buyer will not execute the contract. So he (seller) will keep the option premium to himself – that would be his profit. Hence, the buyer will execute the contract only when the market price of underlying stock is higher than the strike price.
Example 1 – I bought a call option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock.
How call option helps me (the buyer) in realizing profits. Let us assume that the stock price on Jan 24, 2009 is Rs. 1250. Thus, I will execute the call option and you will sell the stock to me for Rs. 1100 and NOT at the current price. I will take that stock from you and sell it for Rs. 1250 in the open market and book a profit of Rs. 1250 – Rs. 1100 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%
Compare this to someone who invested in Infosys stock and NOT in the option. If he bought the stock at Rs. 1000 and sold for Rs. 1250 in the market, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (250* 100 /1000) = 25%
Isn’t it great? One golden rule of investment – Don’t measure your profit or loss based on “absolute value of profit or loss” but on return on investment (ROI).
Remember this – The buyer of a call option will execute the contract only when the market price of the underlying stock will be higher than the strike price of the stock. This is because the buyer will buy the stock from the seller at a lower cost and sell in the open market to book the difference as profit. However, if the market price of underlying stock is less than that of the exercise price, the buyer will let the option expire. In the above example, if the stock price of Infosys on Jan 24, 2009 were Rs. 1090, I will not exercise the contract! Thus, my only loss would be Rs. 100, the option premium that I paid to the seller (you).
Put Options
Put options are options to sell a stock at a specific price on a certain date. Put options mean “right to sell”. It is just the opposite of a call option. The buyer of a put option holds the right to sell while the seller has the obligation to buy. Here, the buyer assumes that the price of underlying asset will go down in future and he will benefit from the put option. Hence, the buyer of a put option will execute the contract only when the market price of underlying stock is lower than the strike price.
Profit realization for the buyer - When do you make profit by selling something? Only when you buy something for X amount and sell it for Y amount where Y>X. Or, you sell someone a product at a price higher than the market price. Why will someone buy a product at a price higher than the market price? He will do it only when he has signed a contract to do so. This is put option which protects and benefits its buyer from any downward movement in the stock price.
State of an option
In-the-Money option – This is when strike price is less than the market price for a call option or the strike price is more than the market price for a put option.
At-the-money – This is when strike price is equal to the market price.
Out-of-the-money – This is when the strike price is more than the market price for the call option while the strike price is less than the market price for the put option.
How to read an option traded listed on an exchange
If you read any business newspaper you may find quotations like this:
INFOSYSTCH Jan 29 CA 1,020.00 51.00 51.00 50.00 51.00
What does this mean? It simply means it is an option with
1. Underlying as Infosys stock
2. Jan 29 is the expiry date
3. to BUY (because it is a “call”) Infosys stock - CA is Call Option
4. 1020.00 is the Strike Price
5. The numbers (51.00, 51.00, 50.00, 51.00) shown after the strike are high price, low price, previous close and Last price respectively.
INFOSYSTCH Feb 26 PA 1,020.00 35.00 35.00 52.00 35.00
It simply means it is an option to SELL (because it is a “put”) Infosys stock with similar details.
Table1: Representation of rights and obligations
CALL
PUT
BUYER (Long)
Right but not the obligation to buy
Right but not the obligation to sell
SELLER (Short)
Obligation to sell
Obligation to buy
Common terminology – people who buy options are also called \"holders\" or are considered to be “Long” on option and, those who sell options are also called \"writers\" or are considered as “Short” on option.
Remember this:
Long –> Buy
Short –> Sell (Selling the right to someone else is like buying obligation for oneself)
Call option –> Right to buy
Put option –> Right to sell (Selling the right to someone else is like buying obligation for oneself)
Long call –> Buy the right to buy
Short call –> Sell the right to buy (Selling the right to someone else is like buying obligation for oneself)
Long put –> Buy the right to sell
Short put –> Sell the right to sell (Selling the right to someone else is like buying obligation for oneself)
Hence, if I buy a call option, I will say “I am Long Call” or “I am a Call Holder”. People who buy options have a right to exercise.
When a Call is exercised, Call holders may buy stock at the strike price from the Call seller, who is required to sell stock at the strike price to the Call holder. When a Put is exercised, Put holders (buyers) may sell stock at the strike price to the Put seller, who is required to buy stock at the strike price from the Put holder. Neither Call holders nor Put holders are obligated to buy or sell; they simply have the rights to do so, and may choose to exercise or not to exercise based upon their own judgment.
Let us discuss example 1 from the point of view of put option in the next example.
Example 2 – I bought a put option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock. The current price of Infosys stock is say, Rs. 1050.
How put option helps me (the buyer) in realizing profits and protecting my interests. Let us assume that the stock price on Jan 24, 2009 is Rs. 950. Thus, I will execute the put option and you will buy the stock from me at Rs. 1100 and NOT at the current price which is Rs. 900. Thus, my profit is Rs. 1100 – Rs. 950 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%
Compare this to someone who invested in Infosys stock and NOT in the option. The value of Infosys stocks has come down from Rs. 1050 to Rs. 950; hence, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (-100* 100 /1000) = - 10% i.e. a loss of 5%.
Gain, Loss and Breakeven Table
Calls
Puts
Long
Short
Long
Short
Maximum gain
Infinite
Premium
Limited
Maximum loss
Premium
Infinite
Breakeven
Market price = Strike Price + Premium
Market Price = Strike Price - Premium
Potential Benefits of Options
• Greater return for smaller amount invested
• Less risk
• Less initial investment
• Diversify portfolio
These previous examples introduced how options can provide investors with more alternatives, allowing them to specify, precisely, the amount of risk they are willing to take in their holdings. If used on a 1-to-1 basis with the underlying shares, then options can be used to invest in stocks with limited risk, to insure stock investments held, or to set levels of market exposure consistent with one\'s investment strategy. Options can also be used as alternatives to stock investments (one option for each 100 shares), giving investors the ability to profit from favorable market moves just as if they held the underlying security, but with lower potential risk due to a lower initial investment.
Final few words
I know you have to read a lot of things which might sound vague and confusing, which is totally understandable. It took me few weeks to completely understand the concepts of F&O! I am not kidding. However, they are wonderful concepts and knowing them only add to your investments knowledge and profile. Go through both Part-1 and Part-2 regularly for sometime. To help you, I have decided to introduce a section on Q&A to test what you learnt in this article. I will publish the answers in the next article.
Test your skills
1. __________ option conveys the right to Buy.
A. Call
B. Put
2. ________ option conveys the right to Sell.
A. Call
B. Put
3. Long on an option means_____.
A. Buy
B. Sell
4. For a call option when the strike price is more than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money
5. For a put option when the strike price is less than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money
6. The buyer of a call option will exercise the option when ____.
A. Strike price is higher than the market price
B. Strike price is lower than the market price
C. Strike price is equal to the market price
Top 4 Questions from our readers – Part 1 of F&O
Q1. One thing I want to ask if I have both long n short positions in future for different share on different scripts and the market moves in reverse direction how can I square off my position with minimum loss. Reader: Binay Mohanty
Answer: You can square off by placing opposite orders on the same scripts i.e. if you are long on XYZ, go short on XYZ and square off your position. Only loss here would be the transaction cost. In case of options, loss will only be the option premium.
Q2. How equities futures are traded please explain with example actually I didn’t understood how equity futures are actually settled? Reader: Nupur Suri
Answer: Futures are traded on exchange – just like stocks. There are ask-bids for them as well. Across the world, equities futures are settled in two ways:
1. Cash settlement – Futures contracts are written on underlying asset. So the buyer and the seller can agree not to take actual delivery of underlying asset. Instead they will do a cash settlement, where the loser will pay difference of price as cash to the winner.
2. Physical delivery – In this case, the seller will make a physical delivery of underlying asset to the buyer and accept cash from the buyer.
However, in India, there is only one way of settling derivatives – Cash Settlement.
Q3. I would also like to ask you about the OTC products and their use. Could you throw some light in the OTC products, in simple language and full depth insight? Reader: Dhritiman Das
Answer: There are thousands of OTC (Over The Counter) products in the market. They are NOT traded on any exchange. Instead a broker writes or facilitates such agreement between the buyer and the seller. These contracts are highly customized to suit the buyer and/or seller specifications. Hence, the contract size, expiry date, settlement type and contract cycles are all customized, which are not possible for exchange traded futures. You can find OTC on forex, bonds, stocks, commodities (gold) etc.
Q4. I wanted to know y does a future contract in equities doesn’t have specified circuit levels while it does in commodity? Reader: Sandeep Lodaya
Answer: I believe you meant circuit breakers. A circuit-breaker is a device that halts trading in a stock if the price changes by a pre-determined percentage on a given day. The stock exchanges currently have 2, 5, 10 and 20 per cent circuit breakers on stocks that are not part of the derivatives segment.
There is not circuit breaker in derivatives because people think it is against free market trade. Believers in free market say that such things will only make investors jittery and create panic. There is circuit breaker in commodity because prices rise or fall in commodities are directly linked to the economy. Hence, government has imposed a circuit breaker on commodity prices
Options
An option is a contract where the buyer has the “right” (depends on buyer to execute it), but not the “obligation” (legally bonded) to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. An option is a security, just like a stock or bond, and constitutes a binding legal contract with strictly defined terms and conditions.
Futures Vs Options
Remember from the previous article, Futures are contracts where both the buyer and the seller have the obligation to honor the contract whereas option does not involve any obligation for both the parties. A contract is a zero sum game i.e. one party will book loss while the other take home the profit. If the contract is futures, the losing party will pay the winning party. However, in options, the buyer will decide whether to execute the contract. You will understand this by the following example.
Let say there is a contract between you and me which says that I will buy one kg of gold at Rs. 1,000 per gm from you on March 1st, 2009. I am the buyer of this contract and you are the seller. So we will either go for cash settlement or you have to deliver the gold to me. Now suppose on the date of settlement i.e. March 1st, 2009, price of gold is Rs. 500 per gram. Thus, the market price of gold on March 1st, 2009 is lower than the contract price.
If the contract were Futures, I would have to buy the gold from you because I have the “obligation” to do so. Hence, I will pay you Rs. 1,000 per gm and you will deliver me the gold. Hence, you make profit while I book loss. Good for you, Bad for me!!
However, if the contract were an Option, I would not have executed it i.e. would not have bought the gold from you. I would have let the contract expire (i.e. do nothing and wait till March 1st, 2009 passes by). How can I do so? I can do it because Options gives me (the buyer) the “right” and not the “obligation” to buy it. Thus, an option would protect me from any adverse movement in the price of underlying asset. In an option, seller has no right because he is compensated by the buyer by paying option premium. Thus, the buyer of an option contract has the “right” but the seller of option contract has the “obligation” to honor the option.
So you may now be wondering that why on earth somebody will ever buy a futures contract when options contract are better. We must know that option has a “premium” attached to it which is called “Options Premium”. This is the amount that a buyer of option contract has to pay the seller of the option contract in exchange for higher flexibility and protection against adverse price movement in the value of underlying. Thus, if I have to buy an option contract from you, I will pay a premium to the seller i.e. You.
Options Vs Stocks
In order for you to better understand the benefits of trading options you must first understand some of the similarities and differences between options and stocks.
Similarities:
• Listed Options are securities, just like stocks.
• Options trade like stocks, with buyers making bids and sellers making offers.
• Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Differences:
• Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).
• Options have expiration dates, while stocks do not.
• There is not a fixed number of options, as there are with stocks available e.g. there could tens or even hundreds of options written on the same stock
• Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.
Remember these options are not issued or written by companies who stocks act as underlying asset. These options are generally written by brokers or traders for investors.
Options Terminology
Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the seller.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract from the seller. The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.
Classes of Options
There are two classes of options – American Option and European Option. The key differences are:
1. American option can be exercised before the expiration while an European option is exercised only on the expiration date.
2. Dividends can be issued by the underlying stock in an American option while it is not the case in European option
Types of Options
There are only two types of options: Call option and Put option. In this article we will discuss only European options i.e. options which can not be executed before the agreed upon date.
Call Options
A Call Option is an option to “buy” a stock (underlying) at a specific price on a certain date. The buyer of call option holds the rights while the seller has the obligation to honor the contract. The buyer of a call option enters the contract assuming that the value of underlying will increase in future and benefit him. The seller thinks otherwise i.e. the stock price will not go up and hence the buyer will not execute the contract. So he (seller) will keep the option premium to himself – that would be his profit. Hence, the buyer will execute the contract only when the market price of underlying stock is higher than the strike price.
Example 1 – I bought a call option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock.
How call option helps me (the buyer) in realizing profits. Let us assume that the stock price on Jan 24, 2009 is Rs. 1250. Thus, I will execute the call option and you will sell the stock to me for Rs. 1100 and NOT at the current price. I will take that stock from you and sell it for Rs. 1250 in the open market and book a profit of Rs. 1250 – Rs. 1100 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%
Compare this to someone who invested in Infosys stock and NOT in the option. If he bought the stock at Rs. 1000 and sold for Rs. 1250 in the market, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (250* 100 /1000) = 25%
Isn’t it great? One golden rule of investment – Don’t measure your profit or loss based on “absolute value of profit or loss” but on return on investment (ROI).
Remember this – The buyer of a call option will execute the contract only when the market price of the underlying stock will be higher than the strike price of the stock. This is because the buyer will buy the stock from the seller at a lower cost and sell in the open market to book the difference as profit. However, if the market price of underlying stock is less than that of the exercise price, the buyer will let the option expire. In the above example, if the stock price of Infosys on Jan 24, 2009 were Rs. 1090, I will not exercise the contract! Thus, my only loss would be Rs. 100, the option premium that I paid to the seller (you).
Put Options
Put options are options to sell a stock at a specific price on a certain date. Put options mean “right to sell”. It is just the opposite of a call option. The buyer of a put option holds the right to sell while the seller has the obligation to buy. Here, the buyer assumes that the price of underlying asset will go down in future and he will benefit from the put option. Hence, the buyer of a put option will execute the contract only when the market price of underlying stock is lower than the strike price.
Profit realization for the buyer - When do you make profit by selling something? Only when you buy something for X amount and sell it for Y amount where Y>X. Or, you sell someone a product at a price higher than the market price. Why will someone buy a product at a price higher than the market price? He will do it only when he has signed a contract to do so. This is put option which protects and benefits its buyer from any downward movement in the stock price.
State of an option
In-the-Money option – This is when strike price is less than the market price for a call option or the strike price is more than the market price for a put option.
At-the-money – This is when strike price is equal to the market price.
Out-of-the-money – This is when the strike price is more than the market price for the call option while the strike price is less than the market price for the put option.
How to read an option traded listed on an exchange
If you read any business newspaper you may find quotations like this:
INFOSYSTCH Jan 29 CA 1,020.00 51.00 51.00 50.00 51.00
What does this mean? It simply means it is an option with
1. Underlying as Infosys stock
2. Jan 29 is the expiry date
3. to BUY (because it is a “call”) Infosys stock - CA is Call Option
4. 1020.00 is the Strike Price
5. The numbers (51.00, 51.00, 50.00, 51.00) shown after the strike are high price, low price, previous close and Last price respectively.
INFOSYSTCH Feb 26 PA 1,020.00 35.00 35.00 52.00 35.00
It simply means it is an option to SELL (because it is a “put”) Infosys stock with similar details.
Table1: Representation of rights and obligations
CALL
PUT
BUYER (Long)
Right but not the obligation to buy
Right but not the obligation to sell
SELLER (Short)
Obligation to sell
Obligation to buy
Common terminology – people who buy options are also called \"holders\" or are considered to be “Long” on option and, those who sell options are also called \"writers\" or are considered as “Short” on option.
Remember this:
Long –> Buy
Short –> Sell (Selling the right to someone else is like buying obligation for oneself)
Call option –> Right to buy
Put option –> Right to sell (Selling the right to someone else is like buying obligation for oneself)
Long call –> Buy the right to buy
Short call –> Sell the right to buy (Selling the right to someone else is like buying obligation for oneself)
Long put –> Buy the right to sell
Short put –> Sell the right to sell (Selling the right to someone else is like buying obligation for oneself)
Hence, if I buy a call option, I will say “I am Long Call” or “I am a Call Holder”. People who buy options have a right to exercise.
When a Call is exercised, Call holders may buy stock at the strike price from the Call seller, who is required to sell stock at the strike price to the Call holder. When a Put is exercised, Put holders (buyers) may sell stock at the strike price to the Put seller, who is required to buy stock at the strike price from the Put holder. Neither Call holders nor Put holders are obligated to buy or sell; they simply have the rights to do so, and may choose to exercise or not to exercise based upon their own judgment.
Let us discuss example 1 from the point of view of put option in the next example.
Example 2 – I bought a put option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock. The current price of Infosys stock is say, Rs. 1050.
How put option helps me (the buyer) in realizing profits and protecting my interests. Let us assume that the stock price on Jan 24, 2009 is Rs. 950. Thus, I will execute the put option and you will buy the stock from me at Rs. 1100 and NOT at the current price which is Rs. 900. Thus, my profit is Rs. 1100 – Rs. 950 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%
Compare this to someone who invested in Infosys stock and NOT in the option. The value of Infosys stocks has come down from Rs. 1050 to Rs. 950; hence, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (-100* 100 /1000) = - 10% i.e. a loss of 5%.
Gain, Loss and Breakeven Table
Calls
Puts
Long
Short
Long
Short
Maximum gain
Infinite
Premium
Limited
Maximum loss
Premium
Infinite
Breakeven
Market price = Strike Price + Premium
Market Price = Strike Price - Premium
Potential Benefits of Options
• Greater return for smaller amount invested
• Less risk
• Less initial investment
• Diversify portfolio
These previous examples introduced how options can provide investors with more alternatives, allowing them to specify, precisely, the amount of risk they are willing to take in their holdings. If used on a 1-to-1 basis with the underlying shares, then options can be used to invest in stocks with limited risk, to insure stock investments held, or to set levels of market exposure consistent with one\'s investment strategy. Options can also be used as alternatives to stock investments (one option for each 100 shares), giving investors the ability to profit from favorable market moves just as if they held the underlying security, but with lower potential risk due to a lower initial investment.
Final few words
I know you have to read a lot of things which might sound vague and confusing, which is totally understandable. It took me few weeks to completely understand the concepts of F&O! I am not kidding. However, they are wonderful concepts and knowing them only add to your investments knowledge and profile. Go through both Part-1 and Part-2 regularly for sometime. To help you, I have decided to introduce a section on Q&A to test what you learnt in this article. I will publish the answers in the next article.
Test your skills
1. __________ option conveys the right to Buy.
A. Call
B. Put
2. ________ option conveys the right to Sell.
A. Call
B. Put
3. Long on an option means_____.
A. Buy
B. Sell
4. For a call option when the strike price is more than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money
5. For a put option when the strike price is less than the market price, it is ____.
A. In-the-money
B. At-the-money
C. Out-of-the-money
6. The buyer of a call option will exercise the option when ____.
A. Strike price is higher than the market price
B. Strike price is lower than the market price
C. Strike price is equal to the market price
Top 4 Questions from our readers – Part 1 of F&O
Q1. One thing I want to ask if I have both long n short positions in future for different share on different scripts and the market moves in reverse direction how can I square off my position with minimum loss. Reader: Binay Mohanty
Answer: You can square off by placing opposite orders on the same scripts i.e. if you are long on XYZ, go short on XYZ and square off your position. Only loss here would be the transaction cost. In case of options, loss will only be the option premium.
Q2. How equities futures are traded please explain with example actually I didn’t understood how equity futures are actually settled? Reader: Nupur Suri
Answer: Futures are traded on exchange – just like stocks. There are ask-bids for them as well. Across the world, equities futures are settled in two ways:
1. Cash settlement – Futures contracts are written on underlying asset. So the buyer and the seller can agree not to take actual delivery of underlying asset. Instead they will do a cash settlement, where the loser will pay difference of price as cash to the winner.
2. Physical delivery – In this case, the seller will make a physical delivery of underlying asset to the buyer and accept cash from the buyer.
However, in India, there is only one way of settling derivatives – Cash Settlement.
Q3. I would also like to ask you about the OTC products and their use. Could you throw some light in the OTC products, in simple language and full depth insight? Reader: Dhritiman Das
Answer: There are thousands of OTC (Over The Counter) products in the market. They are NOT traded on any exchange. Instead a broker writes or facilitates such agreement between the buyer and the seller. These contracts are highly customized to suit the buyer and/or seller specifications. Hence, the contract size, expiry date, settlement type and contract cycles are all customized, which are not possible for exchange traded futures. You can find OTC on forex, bonds, stocks, commodities (gold) etc.
Q4. I wanted to know y does a future contract in equities doesn’t have specified circuit levels while it does in commodity? Reader: Sandeep Lodaya
Answer: I believe you meant circuit breakers. A circuit-breaker is a device that halts trading in a stock if the price changes by a pre-determined percentage on a given day. The stock exchanges currently have 2, 5, 10 and 20 per cent circuit breakers on stocks that are not part of the derivatives segment.
There is not circuit breaker in derivatives because people think it is against free market trade. Believers in free market say that such things will only make investors jittery and create panic. There is circuit breaker in commodity because prices rise or fall in commodities are directly linked to the economy. Hence, government has imposed a circuit breaker on commodity prices
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