Abdus Salam is big into Square Pharma stock and Bangladesh’s stock market in general. But he is concerned about the health of the economy over the next few months as Bangladesh faces a critical foreign reserve crisis.

He thinks that even if Bangladesh comes out ahead of this crisis as a winner, over the next few months, stocks might face a bloodbath due to this looming uncertainty. All he wants is some protection from this risk and to come out of this crisis unscathed.

There are financial derivative instruments that do exactly that in the US and European financial markets. They are called options which are derivative instruments that allow their holders a right to buy (call option) or sell (put option) a specific underlying at a specified price within a given time frame.

Now, that’s a mouthful. An example would clarify it better. Our Abdus Salam, worried that he will lose money in his Square Pharma stock, may decide to purchase a Put Options contract to protect his investment.

How would this work?

So, Square Pharma stock is trading for around Tk 210 a piece[1] and Abdus Salam doesn’t want his stock to go below Tk 200. Abdus Salam could purchase Put Option contracts for 6 months at a strike price of Tk 200 from an options dealer. And if the stock actually falls below Tk 200 within that period, he would be covered by his Put Option as the dealer would bear the loss and Abdus Salam can sleep peacefully knowing that his investment is safe during this crisis period.

Now, why would the options dealer bear this loss?

Basically, the dealer would charge a premium sort of like an insurance premium to Abdus Salam for bearing this risk and would profit if the stock doesn’t fall below Tk 200 within this period.

This is not the only way stock options work, there is Call Option which allows our investor to buy a stock at a specific price which allows our investor to buy a stock at a specified price.

Suppose, Salam thinks that Beximco Pharma stock would jump from its current price (around Tk 150[2]) to a much higher price of around Tk 165 within the next three months because of an upcoming product line. He could buy a Call Option for Tk 155, which would give him the right to buy that stock for that price even if the stock is trading at a much higher price. Thus, he might profit heftily.

This is not the only way options work and there are many more ways our venerable Abdus Salam could transform his return potential by altering his return profile by changing his risk profile using strategies like Covered Calls, Spreads, Strangles etc. Strategies that cannot be explained by this simple blog.