Skip to main content

The Call Option

 The Call Option
Let us now attempt to extrapolate the same example in the stock market context with an intention to understand the ‘Call Option’. Do note, I will deliberately skip the nitty-gritty of an option trade at this stage. The idea is to understand the bare bone structure of the call option contract.
Assume a stock is trading at Rs.67/- today. You are given a right today to buy the same one month later, at say Rs. 75/-, but only if the share price on that day is more than Rs. 75, would you buy it?. Obviously you would, as this means to say that after 1 month even if the share is trading at 85, you can still get to buy it at Rs.75!
In order to get this right you are required to pay a small amount today, say Rs.5.0/-. If the share price moves above Rs. 75, you can exercise your right and buy the shares at Rs. 75/-. If the share price stays at or below Rs. 75/- you do not exercise your right and you do not need to buy the shares. All you lose is Rs. 5/- in this case. An arrangement of this sort is called Option Contract, a ‘Call Option’ to be precise.
After you get into this agreement, there are only three possibilities that can occur. And they are-
  1. The stock price can go up, say Rs.85/-
  2. The stock price can go down, say Rs.65/-
  3. The stock price can stay at Rs.75/-
Case 1 – If the stock price goes up, then it would make sense in exercising your right and buy the stock at Rs.75/-.
The P&L would look like this –
Price at which stock is bought = Rs.75
Premium paid =Rs. 5
Expense incurred = Rs.80
Current Market Price = Rs.85
Profit = 85 – 80 = Rs.5/-
Case 2 – If the stock price goes down to say Rs.65/- obviously it does not makes sense to buy it at Rs.75/- as effectively you would spending Rs.80/- (75+5) for a stock that’s available at Rs.65/- in the open market.
Case 3 – Likewise if the stock stays flat at Rs.75/- it simply means you are spending Rs.80/- to buy a stock which is available at Rs.75/-, hence you would not invoke your right to buy the stock at Rs.75/-.
This is simple right? If you have understood this, you have essentially understood the core logic of a call option. What remains unexplained is the finer points, all of which we will learn soon.
At this stage what you really need to understand is this – For reasons we have discussed so far whenever you expect the price of a stock (or any asset for that matter) to increase, it always makes sense to buy a call option!
Now that we are through with the various concepts, let us understand options and their associated terms

VariableAjay – Venu TransactionStock ExampleRemark
Underlying1 acre landStockDo note the concept of lot size is applicable in options. So just like in the land deal where the deal was on 1 acre land, not more or not less, the option contract will be the lot size
Expiry6 months1 monthLike in futures there are 3 expiries available
Reference PriceRs.500,000/-Rs.75/-This is also called the strike price
PremiumRs.100,000/-Rs.5/-Do note in the stock markets, the premium changes on a minute by minute basis. We will understand the logic soon
RegulatorNone, based on good faithStock ExchangeAll options are cash settled, no defaults have occurred until now.
Finally before I end this chapter, here is a formal definition of a call options contract –
“The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right”.

Comments

Post a Comment

Popular posts from this blog

THE NIFTY FUTURE  Basics of the Index Futures Within the Indian derivatives world, the Nifty Futures has a very special place. The ‘Nifty Futures’ is the most widely traded futures instrument, thus making it the most liquid contract in the Indian derivative markets. In fact you may be surprised to know that Nifty Futures is easily one of the top 10 index futures contracts traded in the world. Once you get comfortable with futures trading I would imagine, like many of us you too would be actively trading the Nifty Futures. For this reason, it would make sense to understand Nifty futures thoroughly. As we know the futures instrument is a derivative contract that derives its value from an underlying asset. In the context of Nifty futures, the underlying is the Index itself. Hence the Nifty Futures derives its value from the Nifty Index. This means if the value of Nifty Index goes up, then the value of Nifty futures also goes up. Likewise if the value of Nifty Index declines
Post a Comment
Read more
 Mutual Funds Basics WHAT ARE MUTUAL FUNDS: A mutual fund is an investment vehicle, which pools money from investors with common investment objectives. It then invests their money in multiple assets, in accordance with the stated objective of the scheme. The investments are made by an ‘asset management company’ or AMC. For example, an equity fund would invest in stocks and equity-related instruments, while a debt fund would invest in bonds, debentures, etc. As an investor, you put your money in financial assets like stocks and bonds. You can do so by either buying them directly or using investment vehicles like mutual funds. In this segment, we will understand mutual funds and how to trade in them. History of mutual funds in India Mutual funds in India have come a long way since 1964 when the Unit Trust of India was the only player. By the end of 1988, UTI had total assets worth Rs 6,700 crore. Soon after, eight funds were established by banks, LIC and GIC between
Post a Comment
Read more
CALL OPTIONS BASICS Breaking the Ice The options market makes up for a significant part of the derivative market, particularly in India. I would not be exaggerating if I were to say that nearly 80% of the derivatives traded are options and the rest is attributable to the futures market. Internationally, the option market has been around for a while now, here is a quick background on the same – Custom options were available as Over the Counter (OTC) since the 1920’s. These options were mainly on commodities Options on equities began trading on the Chicago Board Options Exchange (CBOE) in 1972 Options on currencies and bonds began in late 1970s. These were again OTC trades Exchange-traded options on currencies began on Philadelphia Stock Exchange in 1982 Interest rate options began trading on the CME in 1985 Clearly the international markets have evolved a great deal since the OTC days. However in India from the time of inception, the options market was facilita
Post a Comment
Read more