What are options?
- Options are derivatives contracts that enable the buyer of the contract the right to buy or sell the underlying asset at a predetermined price and quantity on a specified date in the future. The right to buy or sell is without any obligation. The seller of the option has to oblige to buy or sell, should the buyer exercise his or her right.
- The terms of option contracts are standardised to facilitate trading on an exchange.
- They are either cash settled or physically settled.
Features of shout options
- Terms of the contract: As these are exotic options, their terms can be customised and negotiated.
- Traded on: These are traded Over-the-Counter (OTC).
- Premium: Shout options are more costly as compared to standard options because they allow the holder of the instrument the flexibility to lock in profit while still participating in future profit which makes it more risky for the shout option seller. Therefore, the premium is higher.
Types of options: Call and Put
-
Shout Call option
- A shout call option is a derivatives contract that allows the holder of the contract to benefit from an up move in the underlying. The shout call option holder can lock-in the intrinsic value of an option before expiry. This can be done (as negotiated) multiple times at defined intervals before expiry thus allowing the holder of the instrument to continue participating in prospective future gains.
- A shout call option buyer has the right to buy the underlying asset and lock-in the intrinsic value while the call option (seller) writer has an obligation to sell the underlying asset at the predetermined strike price when the buyer of the call option exercises this option.
Let's understand how the shout call option works with the help of an example.
Ms. Divya is a trader who is bullish on ABC Ltd and buys a shout call option of ABC Ltd. Its duration is three months with a strike price of ₹285, she is allowed to shout once (as per the terms negotiated) before expiry.
ABC Ltd is currently trading at ₹280.
The option premium is ₹20 and its lot size is 100.
Total premium = premium x lot size = ₹20 x 100 = ₹2,000.
Break even point for call option = strike price + premium= ₹285 + ₹10 = ₹295.
Ms. Divya can lock in the intrinsic value by 'shouting' at any point when the price of ABC Ltd rises above ₹285, though it will only be profitable when the price increases above ₹295.
After 1 month, ABC Ltd is trading ₹292. Although this is still less than Ms. Divya's break even point, she still decides to shout. This locks-in the intrinsic value of ₹7 (₹292 - ₹285) thus guaranteeing that she won't lose her whole premium (₹10), and will get at least ₹7 worth of it back.
Let's consider two scenarios after the shout at expiry:
Scenario 1: ABC Ltd is currently trading at ₹270.
Here, Shout price > Stock price at expiry i.e. 292 > 270.
As the price drops below ₹292 and stays there until expiry, Ms. Divya still gets the ₹7 in intrinsic value she locked in. In this case, she will still lose ₹3 or ₹300 per contract but not the entire premium.
Loss= (Break even point - Shout price ) x Lot size
= (₹295 - ₹292) x 100 = ₹300.
Therefore, Ms.Divya suffers a loss of ₹300.
Scenario 2: ABC Ltd is currently trading at ₹310.
Here, Shout price < Stock price at expiry i.e. 292 < 310.
As the price rises above ₹292 at expiry, the option has ₹25 in intrinsic value i.e. Option price at expiry - strike price(₹310 - ₹285). Ms.Divya is still able to collect the ₹25 intrinsic value even though she shouted to lock-in ₹7 in intrinsic value. She will still get the higher value since the option expired with greater value than the shout. In this case, she makes ₹15 or ₹1,500 per contract.
Profit= (Stock price at expiry - Break even point) x lot size
= (₹310 - ₹295) x 100 = ₹1,500.
Therefore, Ms.Divya earns a profit of ₹1,500.
Note: In this example, it was negotiated that only one shout would be allowed and the option would be cash settled. However, as shout options are exotic options more shouts and physical settlement can also be negotiated.
-
Shout Put option
- A shout put option is a derivatives contract that allows the buyer to benefit from a down move in the underlying. The shout put option holder can lock-in the intrinsic value of an option before expiry. This can be done (as negotiated) multiple times at defined intervals before expiry thus allowing the holder of the instrument to continue participating in prospective future gains.
- A shout put option buyer has the right to sell the underlying asset at a predetermined price, at a predetermined time while the shout put option seller is obligated to buy the underlying asset at the predetermined strike price when the buyer of the put option exercises this option.
Let's understand how the shout put option works with the help of an example.
Ms. Divya is a trader who is bearish on ABC Ltd and buys a shout put option of ABC Ltd. Its duration is three months with a strike price of ₹285, she is allowed to shout once (as per the terms negotiated) before expiry.
ABC Ltd is currently trading at ₹280.
The option premium is ₹20 and its lot size is 100.
Total premium = premium x lot size = ₹20 x 100 = ₹2,000.
Break even point for put option= strike price - premium= ₹285 - ₹10 = ₹275.
Ms. Divya can lock in the intrinsic value by 'shouting' at any point when the price of ABC Ltd falls below ₹285, though it will only be profitable when the price decreases below ₹275.
After 1 month, ABC Ltd is trading ₹277. Although this is still higher the break even point, she still decides to shout. This locks-in the intrinsic value of ₹8 (₹285 - ₹277) thus guaranteeing that she won't lose her whole premium (₹10), and will get at least ₹8 worth of it back.
Let's consider two scenarios after the shout at expiry:
Scenario 1: ABC Ltd is currently trading at ₹270.
Here, Shout price > Stock price at expiry i.e. ₹277 > ₹270.
As the price drops below ₹277 and stays there until expiry, the option has ₹15 in intrinsic value i.e. strike price - stock price at expiry (₹285 - ₹270). Ms.Divya is still able to collect the ₹15 intrinsic value even though she shouted to lock-in ₹8 in intrinsic value. She will still get the higher value since the option expired with greater value than the shout. In this case, she makes ₹5 or ₹500 per contract.
Profit= (Break even point - stock price at expiry) x lot size
= (₹275 - ₹270) x 100 = ₹500.
Therefore, Ms.Divya earns a profit of ₹500.
Scenario 2: ABC Ltd is currently trading at ₹310.
Here, Shout price < Stock price at expiry i.e. 277 < 310.
As the price rises above ₹277 and stays there until expiry, Ms. Divya still gets the ₹8 in intrinsic value she locked in. In this case, she will still lose ₹2 or ₹200 per contract but not the entire premium.
Loss= (Shout price - Break even point ) x Lot size
= (₹277 - ₹275) x 100 = ₹200.
Therefore, Ms.Divya suffers a loss of ₹200.
Note: In this example, it was negotiated that only one shout would be allowed and the option would be cash settled. However, as shout options are exotic options more shouts and physical settlement can also be negotiated.