Options: Another name for insurance

Almost every one of us has bought some sort of an insurance policy at some or the other point in our life. It may be in the form of life insurance, health insurance, accident insurance, house insurance or any other form of insurance.  The basic aim of almost all insurance is to provide financial protection against losses arising out of an undesired event happening in our lives.

For instance if we buy a house insurance to the tune of Rs 50 lakh by paying a small predetermined premium to the insurance company, it is legally bound to pay us the sum of Rs 50 lakh in case our house is destroyed in earthquake, flood or any other natural calamity. In other words, by paying a very small sum as premium, we can protect ourselves against a huge loss arising out of any unpleasant happening.

All this is just great. But, what about the hard-earned money that we invest in the stock markets?  For many of us this forms a sizable part of our investment kitty. However, no insurance company is foolish enough to insure something that is as uncertain and unpredictable as the stock market. The insurance company would always be a loser in this sort of an arrangement.
So are we left to the mercy of the market makers to decide the fate of our investments in the markets? Well, not really. There is some consolation though. This insurance exists in the forms of Stock Options.

Options are widely used by market players as a form of insurance. Only when it pertains to the markets, the commonly used term for this insurance is Hedging.

Hedging:
A position established with the specific intent of protecting an existing position in case of an unwanted event happening is called hedging.
 In our previous issue, we dealt with the basics of options trading. For the benefit of all, the basic things to under-stand in options trading are:

Option:
It is a contract that gives a buyer the right but not the obligation to buy or sell an underlying asset (index/stock) at a specific price on or before a particular date.

There are two types of Options. One is the Call Option and the other is the Put Option.

Call Option:
Gives the buyer/holder the right to buy the underlying asset at a fixed pre-determined price within a certain fixed period of time

Put Option:
Put Option gives the buyer/holder the right to sell the underlying asset at a fixed predetermined price within a certain fixed period of time.

Option Premium:
The price paid by the buyer of an Option to the seller of an Option is called Option Premium.