Role of Call Options

We are assuming that the person reading this chapter has never traded options and this is a new topic for him. So we start from the very basics here.

A large part of the derivatives business in India comes from option trading. It would not be wrong to say that 80% of the business is in options and the rest in futures. The options market has been running for a long time all over the world. Let us know some things about it:

Options have been available in the over the counter form since 1920. They were mainly used for commodities.

Option trading in equity was started in 1972 at the Chicago Board Options Exchange.

The use of options in currency and bond trading started in the late 70s. These were also OTC i.e. over the counter trades.

Exchange traded options in currency started in 1982 at the Philadelphia Stock Exchange.

Interest rate options started in 1985 at the CME.

Since the OTC trading, there have been many changes and improvements in this market all over the world. Here in our country, option trading has been done through the exchange from the very beginning. In India too, options were available through “Badla Vyapar”. Badla Vyapar can be considered as the unofficial market (grey market) of derivatives. Now Badla Vyapar has been closed. Let us take a look at the history of the Indian derivatives market.

12 June 2000 – Introduction of Index Futures
4 June 2001 – Introduction of Index Options
2 July 2001 – Introduction of Stock Options
9 November 2001 – Introduction of Single Stock Futures

Although the options market was running since 2001, it gained momentum in 2006, and liquidity also increased in it then. In 2006, there was a split between the Ambani brothers and both of them got their companies listed separately in the market. In this way, the capital of the shareholder increased in the market. In my opinion, after this incident, a lot of liquidity started coming in the market. However, in terms of liquidity, Indian futures markets are still far behind other markets in the world.

We are assuming that the person reading this chapter has never traded options and this is a new topic for him. So we start from the very basics here.

A large part of the derivatives business in India comes from option trading. It would not be wrong to say that 80% of the business is in options and the rest in futures. The options market has been running for a long time all over the world. Let us know some things about it:

Options have been available in the over the counter form since 1920. They were mainly used for commodities.

Option trading in equity was started in 1972 at the Chicago Board Options Exchange.

The use of options in currency and bond trading started in the late 70s. These were also OTC i.e. over the counter trades.

Exchange traded options in currency started in 1982 at the Philadelphia Stock Exchange.

Interest rate options started in 1985 at the CME.

Since the OTC trading, this market has seen a lot of changes and improvements across the world. Here in our country, option trading has been done through the exchange since the beginning. In India too, options were available through “Badla Vyapar”. Badla Vyapar can be considered as the unofficial market (grey market) of derivatives. Now Badla Vyapar has been closed. Let us take a look at the history of the Indian derivatives market.

12 June 2000 – Introduction of Index Futures
4 June 2001 – Introduction of Index Options
2 July 2001 – Introduction of Stock Options
9 November 2001 – Introduction of Single Stock Futures

1.2- Special Agreement

Options are of two types, call options and put options. You can buy or sell these options. The shape of your P&L depends on whether you are a buyer or seller of the option. We will discuss this later, for now let us understand what a call option is. To understand call options, let us take a common life example. Suppose there are two good friends Ajay and Venu. Ajay wants to buy 1 acre of land from Venu. The price of this land is ₹500000. Ajay has come to know that in the next 6 months a new highway is going to be built in that area, due to which the value of Venu’s land will increase significantly. That is why Ajay wants to earn money by investing in this land. But if this news of highway construction turns out to be false, then Ajay will be stuck after buying land from Venu. If no highway comes there, then the value of the land will not increase and Ajay will not get any benefit from that land.

In such a situation, what should Ajay do now? You can understand that this is a dilemma for Ajay. He is not able to understand whether he should buy the land from Venu or not. On the other hand, Venu is very clear about this matter that if Ajay wants to buy the land, then he is ready to sell his land.

Ajay now wants to find a way so that his investment remains safe. For this, he prepares a special type of agreement. Ajay believes that this agreement is beneficial for both him and Venu. The details of this agreement are as follows:

Ajay deposits a fee of ₹100000 with Venu right away. This is the fee which he will not get back and it should be considered as the fee of this agreement.

In return for this fee, Venu agrees to sell the land to Ajay after 6 months.

The price of the land for sale after 6 months is fixed today itself – ₹500000

Since Ajay has paid a fee of ₹100000, he gets the right to cancel the agreement after 6 months if he wants. But Venu cannot do so.

If Ajay cancels this agreement after 6 months, then Venu will have the right to keep the fee of ₹100000 with him.

So what do you think about this special agreement? Who is smarter between Ajay and Venu? Who is smarter, Ajay who made such an agreement or Venu who is agreeing to this agreement? The answer to these questions is not easy. To get the answer, you have to understand the details of this agreement very well. If you read and understand the example of this agreement carefully, you will also understand about the option. Ajay has made a very smart agreement. This agreement has many aspects.

Let’s try to understand this agreement:

By paying an agreement fee of ₹ 100000, Ajay has put a restriction on Venu. Venu cannot sell this land to anyone else except Ajay for the next 6 months.

Ajay has also decided that he will get the land at today’s price i.e. ₹ 500000, no matter what the price of the land becomes in the next 6 months. For this he has decided to pay ₹100000 separately.

After 6 months if Ajay decides not to buy the land then he can refuse Venu for this agreement but since Venu has taken the agreement fee from Ajay, Venu cannot say no to Ajay.

There can be no change in the agreement fee, nor this fee is going to be refunded.

After making this agreement, now Ajay and Venu have to wait for the next 6 months to know what will happen next. Whether the price of the land will go up or down will depend on whether the decision to build the highway comes out or not. But whatever be the decision about the highway, in this case now only 3 outcomes can come out –

If the highway is decided to be built, the land price may go up and reach ₹10,00,000.

If the highway is not built, people will be disappointed and the land price may drop to ₹300,000.

Neither of these two happens and the land price may remain at ₹500,000.

There can be no other outcome than these 3 outcomes.

Now let us try to understand what Ajay will do in these three different scenarios.

Scenario 1 – The price goes up to ₹10,00,000

The highway project starts as expected and the land price goes up. Although Ajay has the option to cancel the deal, since the land price has gone up, Ajay will continue with the deal as he will now get the benefit.

Current price of land = ₹1000000

Price of land as per agreement = ₹500000

This means Ajay has a piece of land which he can buy for ₹500,000 whereas the price of the same land in the market is ₹10,00,000. This means Ajay is making a huge profit. So Ajay will now ask Venu to sell the land to Ajay. Venu has no choice but to sell the land to Ajay because he has already taken ₹100,000 from Ajay 6 months ago as per the agreement.

So how much money did Ajay make?

Purchase price = ₹500,000

Agreement fee = ₹100,000

Total expenses = 500,000 + 100,000

= ₹600000

Current price of land = ₹1000000

Ajay’s profit = 10,00,000- 600,000

= 400,000

If we look at it another way, Ajay has earned four times the money on his investment of ₹100000. On the other hand, Venu knows that the price of this land in the market is very high now but he has to sell this land to Ajay at a lower price and in this whole deal, Venu is suffering the same loss as Ajay is earning profit.

Scenario 2 – The price goes down to ₹300,000

It turns out that the highway project was just a rumour and no project is coming up there. People get disappointed and there is a rush to sell the land there due to which the price of the land goes down to ₹300,000. What do you think Ajay will do in such a situation? It is clear that buying land in such a situation will be a very loss-making deal, so Ajay will walk out of this deal. Let us see the math of why this deal is a loss-

You remember that the price of this land was fixed at ₹500,000. Ajay will have to pay ₹500,000 to buy it. Even before this, Ajay has separately paid ₹100000 as agreement fee. This means that Ajay will have to pay a total of ₹600,000 for this land while the price of the land has reached three lakhs. So it is clear that Ajay will have to exit the deal to avoid further loss. He has this right too. In this case, Ajay will lose only ₹100,000 because he has already paid this amount as agreement fee.

Scenario 3

Price remains stuck at 500,000 If for some reason, even after 6 months, the price of the land remains stuck at 500,000 and there is no change in it. So what will Ajay do? Actually Ajay will not buy this land because he will not get any benefit in this deal. Let’s see –

Price of land = ₹500,000

Agreement fee = ₹100,000

Total ₹600,000

Market price of land = ₹500,000 So it is clear that paying ₹600,000 for something that costs ₹500,000 is not a wise deal. Ajay has paid ₹100,000 as agreement fee, so now if he buys the land, he will have to pay ₹600,000. So it is wise for Ajay to let go of ₹100,000 and not buy the land.

Now you must have understood how this deal is working. You will be happy to know that an option deal works exactly like this. But before knowing how it works in the stock market, let us know some more things with this example.

Let us look at some questions and their answers which will help you in understanding these things and understanding options further –

Why do you think Ajay made this deal when he knew that if the price of the land does not increase or if the price of the land goes down then he will incur a loss of ₹100,000?

It is true that Ajay will incur a loss of ₹100,000 but Ajay knows that the maximum loss he will incur is ₹100,000 and after that there is no scope for further loss. But if the price of the land increases then his profit can be many times and if it reaches ₹10,00,000 then he will make a profit of ₹400,000 whereas he has invested only ₹100,000.

This means that he will make a profit of 400%.
Under what circumstances will such a deal be beneficial for Ajay?
Only if the price of the land increases
Under what circumstances will this deal be beneficial for Venu?
In that case, the land price will either fall or remain stable.

Why is Venu taking this risk? If the land price rises after 6 months, he may suffer a huge loss.

Just think, there can be only three scenarios and two of those three scenarios are beneficial for Venu. This means that Venu has a 66.66% chance of making a profit from this deal while Ajay has only a 33.33% chance of making a profit.

Now let us briefly look at some important points.

Ajay makes an initial payment to Venu to ensure that he has the right to accept or reject the deal. Also, Venu has an obligation to follow Ajay’s word.

The outcome of this agreement will depend on the price of the land after 6 months. Without land, this agreement has no value.

So, the land will be called the underlying and this agreement will be called a derivative.

This kind of agreement is called an option agreement.

Since Venu has received an initial advance from Ajay, Venu will be called the seller or writer of the agreements and Ajay will be the buyer of the agreements.

In other words, since this is an option agreement, Ajay will be called the option buyer and Venu will be called the option seller or writer.

This agreement has been made after paying ₹100,000, so the price of this ₹100,000 will be called the price of the option agreement. It is also called the premium.

The price of the land, the measurement of the land, the date of sale, everything is fixed in the agreement.

In an option agreement, the buyer always has the option or right while the seller has the responsibility.

My advice is that you should understand this example properly and if you have not been able to understand it, then read it once again and try to understand it because this example will also be useful to you in the upcoming chapters. Now based on this example, let us move forward and look at this agreement from the perspective of the stock market.

1.3 – Call Option

Let us try to understand how call option works in the stock market through the above example. I am deliberately not telling many details of option trading here because I want those people to understand this right now who do not know anything about it.

Suppose a stock is selling at ₹ 67 and you get the right to buy that stock after 1 month at ₹ 75 and you also have the right to buy this stock only when the market price of the stock is more than 75. Now will you buy the stock? You will definitely buy it because you are getting a chance to buy this stock after a month at ₹ 75 even if this stock is at ₹ 85 in the market.

To get the right to buy this stock after a month at ₹ 75, you will have to pay a fee of ₹ 5. If this share goes above ₹ 75, you can use this right and buy the share at ₹ 75. But if the share price remains at ₹ 75 or goes below it, you will not use this right and it will not be necessary for you to buy the share. You will only lose ₹ 5. This kind of agreement is called an option contract or to be more precise, it is called a call option.

If you make such an agreement, there are only three possibilities –

The share price can go up, say to 85.

The share price can go down, say to 65.

The share price can remain at its place, i.e. at 75.

Possibility 1 – If the share price goes up, you should use your right and buy the share.

Now your P&L will look like this

Price at which the share was bought = ₹75

Premium paid = ₹5

Total expenses = ₹80

Market price of the share = ₹85

Profit earned = ₹5

Possibility 2 – If the share price goes down, say to ₹65, then there is no benefit in buying this share at ₹75. Then you will be spending ₹80 (75+5) for a share which is available in the market at ₹65.

Possibility 3 – If the share price remains stable at its place i.e. ₹75, then it means that you will be spending ₹80 to buy a share which is available in the market at ₹75. In such a situation, there is no point in buying this share again. You will not exercise your right to buy.

So this is how the option works. Now you must have understood this. It is also important to understand other things related to this. But we will learn them later.

Now at this point it is important for you to understand that when the price of a stock is expected to rise, then buying a call option is a better option.

variable basis	Ajay –Venu Souda	Share Example	Comment
Underline	1 acres of land	Stock	Remember that the principle of lot size works in options, just like in the land agreement the land was one acre, neither less nor more, similarly in the option agreement the lot size will be
Expiry	6 Months	1 Month	There are three expiries like in futures market
fixed price	Rs.500,000/-	Rs.75/-	This is called the strike price.
Premium	Rs.100,000/-	Rs.5/-	Remember that the premium in the stock market changes every minute. We will talk about this later.
regulators	None, based on faith	Stock Exchange	All options are cash settled. There has been no default till date

Before ending this chapter, let me give you the formal definition of a call option –

The buyer of a call option has the right, but not the obligation, to buy a fixed quantity of the commodity (commodity, shares, land, etc.) agreed upon in the agreement from the seller of the option at a fixed price (strike price) at a fixed time (expiry). The seller has the obligation to sell the fixed quantity of the commodity to the buyer at the fixed price. The buyer pays a fee (premium) for this right.

We will learn more about call options in the next chapter.

Highlights of this chapter

1. Options have been traded in the Indian markets for the last 15 years, but liquidity in it has increased since 2006.
2. Options are a method of trading that protects your position and reduces your risk.
3. The buyer of a call option has the right and the seller has the obligation to deliver.
4. In any option agreement, only one party gets the option (i.e. right) and that is the buyer.
5. The seller of the option is also called the option writer.
6. At the time of the agreement, the buyer of the option pays a fixed amount to the option seller, this is called the premium.
7. The option agreement is for a fixed price, this price is called the strike price.
8. The buyer of the option makes a profit when the price of the asset goes above the strike price.
9. If the price of the asset remains below the strike price or remains at its place, then the buyer does not benefit, that is why the option should be bought only when you expect that the price of the asset will go up.
10. According to statistics, the seller of the option has a higher chance of profit in the agreement.
11. Your guess on where the price will go should turn out to be correct by the day of expiry. If your opinion does not prove to be correct by that day, then the option agreement becomes useless.