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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”.

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