What are Options in Stock Market? Understanding Call Options

What are the Options?

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

A major part of derivatives trading in India comes from options trading. It would not be wrong to say that 80% of trading takes place in options and the rest in futures. Options markets around the world have been around for a long time. Let’s know a few things about it:

Over-the-counter options have been available since 1920. They were mainly used for commodities.
The use of options trading in equities began in 1972 on the Chicago Board Options Exchange.

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

Exchange-traded options in the currency began in 1982 on the Philadelphia Stock Exchange.
Interest rate options were introduced in the CME in 1985.

Across the world, this market has been undergoing a lot of changes and improvements since OTC trading. Here in our country, option trading is done through the exchange from the very beginning. By the way, the option was available in India also through “Badla Vyapar”. Badla trading can be considered as the unofficial gray market of derivatives. Now the revenge business is closed. Let’s take a look at the history of the Indian derivatives market.

• 12 June 2000 – Index futures launch
• June 4, 2001 – Index option launched
• July 2, 2001 – Stock options launch
• 9 November 2001 – Launch of single stock futures

Although the options market was operating since 2001, it picked up momentum in 2006, and the liquidity in it also increased only 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 shareholder’s capital increased in the market. In my opinion, a lot of liquidity started coming into the market after this incident. However, in terms of liquidity, the Indian futures markets are still far behind compared to other markets in the world.

Special Agreement

There are two types of options, call options and put options. You can buy or sell these options. The profile of your P&L depends on whether you are a buyer or seller of options. We will discuss this later, for now, let us understand what is a call option? To understand the call option let’s take a simple life example.

Suppose there are two good friends Ajay and Venu. Ajay wants to buy 1 acre of land from Venu. The cost of this land is ₹ 500000. Ajay has come to know that a new highway is going to be built in that area in the next 6 months, due to which the cost of Venu’s land will increase significantly. That’s why Ajay wants to earn money by investing in this land. But if the news of this highway being built turns out to be wrong, then Ajay will be trapped by taking land from Venu. If there is no highway there then the price of the land will not increase and Ajay will not get any benefit from that land.

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

Ajay now wants to find a way out so that his investment is safe. For this, a special type of agreement is prepared. Ajay believes that this agreement is a win-win deal for both him and Venu. The details of this agreement are as follows-

• Ajay immediately deposits a fee of ₹ 100000 with Venu now. This is a fee that will not be refunded to him and should be treated as a fee for this Agreement.
• In exchange for this fee, Venu agrees to sell the land to Ajay after 6 months.
• After 6 months the price of land for sale is fixed today itself – ₹ 500000
• Since Ajay has paid a fee of ₹ 100000, he has the right to cancel the agreement after 6 months if he so desires. But Venu cannot do that.
• If Ajay cancels the agreement after 6 months, Venu will be entitled to retain the fee of ₹ 100000.

So what do you think this particular agreement is like? Who is smarter between Ajay and Venu? Is Ajay the one who makes such an agreement smarter or is Venu who is accepting this agreement? Answering these questions is not easy. To get the answer you need to understand the details of this agreement thoroughly. If you read and understand the example of this agreement carefully, then you will also understand about the option. Ajay has made a very clever pact. There are many aspects to this agreement.

Let’s try to understand this agreement:

• Ajay has imposed a ban on Venu by paying an agreement fee of ₹ 100000. Venu cannot sell this land to anyone other than Ajay for the next 6 months.
• Ajay has also decided that he will get the land at today’s price i.e. ₹ 500000. Whatever happens to the cost of the land in the next 6 months. For this, he has decided to give ₹ 100000 separately.
• After 6 months if Ajay decides not to buy the land then he can convince Venu for this agreement but since
• Venu has taken the settlement fee from Ajay, Venu cannot say no to Ajay.
• There cannot be any change in the agreement fee, nor is this fee refundable.

After making this deal, Ajay and Venu now have to wait for the next 6 months to know what will happen next. The cost of land will go up or down depending on whether the decision to build a highway comes or not. But whatever be the decision about the highway, in this case now only three results can come out –

If it is decided to build a highway, then the price of the land can go up a lot and the price can also reach ₹ 1000000.

If the highway is not built then people will be disappointed and the price of the land can drop to ₹ 300000.
Neither of the two happens and the price of the land can remain at ₹500000.

There can be no result other than these 3 results.

1. Now let us try to understand what Ajay will do in these three different situations.
2. Scenario 1 – Price moves up to ₹10,00,000

As expected by Ajay, the highway project gets started and the cost of the land increases. Although Ajay has the option to cancel the deal, but because the land prices have gone up, Ajay will continue this deal as now he will get the benefit.

Present cost of land = ₹1000000

According to the agreement, the cost of the land = ₹ 500000

This means that Ajay has a piece of land that he can buy for ₹ 500,000 while the market value of the same land is ₹ 10,00,000. This means that Ajay is getting a lot of profit. So Ajay will now ask Venu to sell the land to Ajay. Venu has no way but to sell the land to Ajay as under that agreement he has already taken ₹100,000 from Ajay 6 months back.

So how much money did Ajay make?

Purchase Price = ₹500,000

Agreement fee = ₹100,000

Total expenses = 500,000 + 100,000

= ₹ 600000

Present cost of land = ₹1000000

Ajay’s profit = 10,00,000- 600,000

= 400,000

If we look in 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 Venu is losing as much profit as Ajay is getting in this whole deal. .

Scenario 2 – Price goes down to ₹300,000

It turns out that the highway project was just a rumor and there are no projects coming up. People get frustrated and there is a competition to sell the land, due to which the price of the land reaches 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 lossy deal, so Ajay will walk out of this deal. Let’s see the math of why this deal is a loss-

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

Scenario 3 – Price remains at 500,000 if for some reason even after 6 months the price of land remains at 500,000 and there is no change in that. So what will Ajay do? Actually, Ajay will not buy this land as he will not get any benefit in this deal. let’s watch –

Land cost = ₹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 given an agreement fee of ₹100,000, so now if he buys the land, he will have to pay ₹600,000. Therefore, it is wise to let Ajay 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 option trading works exactly like this. But before knowing how it works in stock market let us know few more things with this example.

Let’s look at some questions and their answers, which will help you more in understanding these things and understanding the options-

Why do you think Ajay did this deal when he knew that he would lose ₹100,000 if the land price didn’t increase or the land price went down from his place?

• It is true that Ajay will suffer a loss of ₹100,000 but Ajay knows that his maximum loss will be ₹100,000 and there is no further scope for loss after that. But if the price of the land increases then his profit can be manifold and if it reaches to ₹ 10,00,000 then he will make a profit of ₹ 400,000 whereas he has invested only ₹ 100,000. This means he will have a profit of 400%.
• Under what circumstances would such a deal be beneficial for Ajay?
• Only in case land prices will increase
• Under what circumstances will this deal be beneficial for Venu?
• In the event that land prices will either fall or remain stable in place
• Why is Venu taking this risk, if land prices go up for 6 months, then he may suffer a lot.

Just imagine, there can be only three situations here and out of those three situations, two are beneficial for Venu. This means that Venu expects 66.66% profit from this deal while Ajay has only 33.33% chance of profit.

Now let’s briefly look at some important points

1. Ajay makes an upfront payment to Venu to ensure that he has the right to accept or cancel the deal. Also, Venu has an obligation to obey Ajay.
2. The outcome of this agreement will be based on the value of the land after 6 months. There is no value of this agreement without land.
3. Therefore the land would be called the underlying and the agreement would be called a derivative.
   Such an agreement is called an option agreement.
4. Since Venu has received initial advance from Ajay, Venu will be called the seller or writer of the agreements and Ajay will be the buyer of the agreement.
5. In other words, since it is an option agreement, Ajay will be called an option buyer (buyer) and Venu will be called an option seller or writer.
6. This settlement is done after paying ₹100,000 so this price of ₹100,000 will be called the price of the option agreement. It is also called premium.
7. The price of the land, the measurement of the land, the date of sale, everything is fixed in the agreement or agreement.
8. In an option agreement, the buyer always has the option or right while the seller has the obligation.

My advice is that you should understand this example well and if you have not understood then try to understand by reading it once again because this example will be useful to you in the next chapters as well. Now on the basis of this example let us go ahead and look at this agreement from the perspective of the stock market.

Call Option

Let us try to understand through the above example how call options work in the stock market. I am deliberately not sharing a lot of information about options trading here because I just want it to be understood by those who do not know about it at all.

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

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

If you make such a deal then there are only three possibilities –

The share price may go up, let’s say, up to 85%.
The share price may go down, let’s say, up to 65.
The share price may remain in its place, i.e. at 75.

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

Your P&L will now look like this

Price at which the share was bought = ₹75

Premium paid = ₹5

Total Expense = ₹80

The market price of the share = ₹85

Profit made = ₹5

Possibility 2 – If the share price goes down let’s say by 65, then there is no point in buying this share at ₹75. Then you would be spending ₹80 (75+5) for a share that is getting ₹65 in the market.

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

So the option works like this. Now you must have understood this. Other things related to this are also important to understand. But we will learn them later.

Right now at this place, 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.

Let’s take a look at some of the principles and terms related to options

variable base	Ajay Venu Deal	Share Example	Description
Underlying	1 Acre Land	Stock	Remember that the principle of lot size in options works as if the land in the agreement of land was one acre, neither less nor more, similarly the lot size in the option agreement would be
Expiry	6 Months	1 Month	Like the futures market, there are three expiry
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. Will talk about this further.
Regulator	None, based on faith	Stock Exchange	All options have a cash settlement. no default till date

Before I conclude 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 specified quantity of the commodity (commodity, shares, land, etc.) stipulated in the agreement at the specified time (expiry), at the specified price (strike price) of the option. Buy from the seller. It is the obligation of the seller to sell the specified quantity of the specified commodity to the buyer at the specified price. The buyer pays a fee (premium) for this right.

In the next chapter, we will learn more about call options.

Highlights of this chapter

• Buying and selling of options in the Indian markets have been happening for the last 15 years but the liquidity in it has increased since 2006.
• Options trading is a way to protect your positions and reduce your risk.
• The buyer of a call option has the right and the seller has an obligation to make delivery.
• In any option agreement, only one party gets the option (i.e. right) which is the buyer.
• An option seller is also called an option writer.
• At the time of the agreement, the buyer of the option pays the seller of the option a certain amount, which is called the premium.
• The option agreement is for a fixed price, this price is called the strike price.
• An option buyer makes a profit when the asset price moves above the strike price.
• The buyer does not profit if the asset price stays below the strike price or remains in place, so buy the option only when you expect the asset price to go up.
• Going by the statistics, the seller of the option is more likely to make a profit in the settlement.
• Your guess on where the price will go should be correct by the day of expiry. If by that day your opinion is not proved correct then the option agreement becomes void.