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Equity Options

Definition of Equity Options

An equity option gives the holder the right but not the obligation to buy or sell the underyling shares at a pre-agreed price and date. Equity options are derivative contracts that derive value from underlying shares.

Every equity option comes with a lot size that specifies the total number of underlying shares the contract contains. A trade who wants to start options trading can procure the derivative contract by paying a premium.

Related Terms

Equity Shares

Equity shares is a term used to describe stock of a company that’s issued via an Initial Public Offer (IPO), already issued and traded on the stock market, or freshly available through a Follow on Public Offer (FPO).

For a company, the goal of issuing equity shares is to raise money while investors who buy these equity shares get perks like voting rights, dividends, and even a share of the assets in case the company is liquidated.

Averaging Down

Averaging down means buying more shares when the price drops, thereby bringing down your overall average cost of investing. For example:

Day 1 (Normal price)

  • Shares bought of XYZ: 10
  • Price of each share: Rs. 1000
  • Total cost of investing: Rs. 10,000
  • Average investment cost: Rs. 1000


Day 2 (Lower price)

  • Shares bought of XYZ: 10
  • Price of each share: Rs. 900
  • Total cost of investing: Rs. 9,000
  • Average investment cost: Rs. 900


Averaging Down

  • Initial average cost of investing (Day 1): Rs. 1000
  • New average cost of investing (Day 1 & Day 2): Rs. 950

Equities

The term equities can be used to describe two different things. First, equities refers to stocks held by shareholders. Equities of this type represent residual ownership or stake in a company.

Second, equities are the amount of money shareholders shall receive in the event that a company is liquidated. In such a case, the equities will be calculated by subtracting the total debt from total assets.

Compounded Annual Growth Rate (CAGR)

Compounded Annual Growth Rate shows how much returns on average an investment can generate over a year, given the data for a period of time (say 5+ years).

CAGR is an indicative measure of yearly returns growth that assumes the profits are reinvested. The formula to calculate Compound Annual Growth Rate is:

CAGR = [(Ending value/Beginning Value)^(1/N)]-1

Cash Market

A cash market is a place where assets, goods, and services are bought and sold on the spot. That’s why it is also known as the “spot market”.

A stock market exchange like NSE or BSE is an example of a cash market as trades are settled on the spot at the spot price. Derivatives like futures are not a part of the cash market are trades are settled in the future.

Basis Of Allotment

The basis of allotment is the criteria to allocate shares to investors, most commonly during IPOs. Criteria or basis for allotment lays out the following information:

The difference between the spot and futures prices forms the “basis” for the trading strategy. Hence the name basis trading. These are the two ways in which a trader may use the basis:

  • Share allocation ratio
  • Bids
  • Demand
  • Final price

The basis of allotment can vary based on the type of investor in question. Bidders during an IPO for whom a different basis of allotment applies include:

  • Retail Individual Investors (RII)
  • Qualified Institutional Buyer (QIB)
  • Non-Institutional Buyers (NIBs)
  • High Net-worth Individuals (HNIs)
  • Anchor Investors



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