1.1 -Opening the way

We will assume that you are unfamiliar with options and do not know much about them, just as we did in the other modules of Varsity. We will therefore start from scratch and gradually increase our knowledge as we go.Using some basic background information let us start.

India's options market accounts for a large portion of the global derivatives market. It would not be an exaggeration to say that almost 80% of derivatives traded in India are options, and the remainder is due to the futures markets. The option market is well-established internationally. Here's a brief history.

• Since the 1920's, custom options were offered as Over the Counter (OTC). These options were mostly available for commodities
• Options on equities were first traded on the Chicago Board Options Exchange in 1972
• In the late 1970s, options on bonds and currencies were available. These were once again OTC trades
• Exchange-traded options for currencies were first introduced at the Philadelphia Stock Exchange in 1982.
• In 1985, interest rate options were first traded on the CME

The international markets have changed a lot since OTC. The exchanges enabled the Indian options market to develop from its inception. Options were also available in the off-market 'Badla’ system. The 'badla' system can be thought of as a grey marketplace for derivatives transactions. It is no longer in existence. Here's a brief overview of the Indian derivative markets' history.

• June 12, 2000 - Index futures launched
• June 4, 2001 -Index Options were Launched
• July 2, 2001 - Stock options launched
• November 9, 2001 - Single stock futures launched.

Although options trading has been around since 2001 the Indian index options were only able to offer real liquidity in 2006. Trading options was very difficult at that time. Spreads were huge and filling orders was hard. In 2006, however, the Ambani brothers split up and each of their companies was listed as a separate entity. This allowed them to unlock the shareholder value. This corporate event created some serious liquidity and vibrancy in Indian markets. We still have a lot to learn if we compare Indian stock options liquidity with international markets.

1.2 - A view to Special agreement

There are two options available: the Call option or the Put option. These options can be bought or sold by you. The P&L profile will change depending on what you do. We will explore the P&L profile in a later stage. Let's first understand "The Call Option". The best way to get to grips with the call option is to use a real-world example. Once we have this understanding, we can then extrapolate it to stock markets. Let's get started.

This is how it works: Ajay and Venu are good friends. Venu's land is being offered for sale to Ajay.Venu informed Ajay that Venu  the land which is rs. 500000/- is likely to approve a new highway near Venu's land in the next six month. If the highway is built, Ajay will be able to reap the benefits of the investment today. Ajay could still benefit from the investment if the "highway news", which would mean Ajay buys the land from Venu today, but there's no highway tomorrow, would be a rumor

What should Ajay do now? This situation clearly has Ajay in a quandary as he is unsure if he should buy the land from Venu. Ajay's confusion is evident, but Venu is very clear about Venu selling the land if Ajay wants to buy it.

Ajay doesn't want to risk it, so he analyzes the situation and proposes Venu a structured arrangement. Ajay believes that Venu is the winner.The arrangement details:-

1. Ajay today pays a Rs.100,000. This is a non-refundable agreement fee that Ajay charges.
2. Venu agrees to pay these fees and sells the land to Ajay after six months.
3. Today's price for the sale (which is expected to take place 6 months later) was fixed at Rs.500,000/.
4. Ajay paid an upfront fee and can only cancel the contract after 6 months. Venu cannot.
5. Venu will keep the upfront fees if Ajay cancels the deal after 6 months.

What do you think of this agreement? Which do you think is smarter? Venu or Ajay, for proposing this tricky agreement? The answer to these questions can be difficult to find if you don't carefully read the details. You should read the following example (it is also the basis for understanding options) - Ajay has crafted an amazing deal! This deal actually has many faces.

Let's take a look at Ajay’s proposal and get to the bottom of it.

• Venu is bound by Ajay's agreement fee of Rs.100,000. Venu is forced to agree for Ajay to lock the land for the next six months
• Ajay will fix the sale price for the land on the current price, i.e. Rs.500,000/-. This means that he can buy the land at the current price regardless of what the future price is. He is setting a price and will pay an additional Rs.100,000.
• If Ajay doesn't want to purchase the land after the six-month period, Venu can say so. However, Venu has already paid the agreement fee to Ajay. Venu cannot say no to Ajay.
• The agreement fee cannot be negotiated or refunded.

Ajay and Venu now have to wait six months after they sign the agreement to find out what would happen. The outcome of the highway project will determine the final price of the land. There are only three outcomes that could happen to the highway regardless of how it turns out.

1. The price of land will rise once the highway project is completed. It could go up to Rs.10,00,000.
2. People are disappointed that the highway project is not realized, and the land prices plummet to around Rs.300,000.
3. There is no change, the price remains constant at Rs.500,000/.

There are no other outcomes than the ones I have already mentioned.

Now, we will put ourselves in Ajay's shoes to see what he would do in each one of these situations.

Scenario 1: Price increases to Rs.10,00,000.

The land price has increased since the highway project was completed as Ajay had expected. Ajay can cancel the agreement at any time after 6 months. Do you think Ajay would call off the deal due to the rise in land prices? The dynamics of the sale favor Ajay, but that's not the case.

Current market price for the land = Rs.10,00,000.

Value of sale agreement = Rs.500,000/

Ajay can now buy land for Rs.500,000/-, whereas the same land on the open market is selling for Rs.10,00,000. This is clearly a steal deal. He demanded Venu sell the land. Venu is bound to sell the land at a lower price because Ajay had paid Rs.100,000./- fees six months prior.

How much is Ajay earning? Here's the math:

Buy Price: Rs.500,000/

Add: Agreement fees = Rs.100,000. (Remember, this is non-refundable).

Total Expense = 500,000 + 100 000 = 600,000./-

Current Land Market = Rs.10,00,000.

His profit is thus Rs.10,00,000.- Rs.600,000. = Rs.400,000/ -

A different way to view this is: Ajay now makes 4x the money for a Rs.100,000. Venu, even though he knows the land's value is higher on the open market than it is in his home, has to sell it to Ajay at a lower price. Venu would suffer a loss of Rs.400,000 if Ajay made the same profit.

   Scenario 2 - Price went dpwn to Rs. 3 lakhs  

The highway project was a rumour and it is not likely that anything will come of it. People are disappointed, and there is an immediate rush to sell the land. The land's price drops to Rs.300,000.

What do you think Ajay will do? It is clear that it doesn't make sense to purchase the land. Therefore, he would not sign the deal. This is the math to explain why it doesn't make sense to purchase the land.

The sale price was fixed at Rs.500,000/month six months ago. Ajay must pay Rs.500,000 to purchase the land. He also had to pay Rs.100,000./- for the agreement fees. He is effectively paying Rs.600,000. To buy a piece worth Rs.300,000. This would make no sense to Ajay. He has the right of calling the deal and would walk away. But, Venu will get Rs.100,000. Ajay must give up Rs.100,000.

Scenario 3 - Price stays at Rs.500,000/-

Whatever reason, the price remains at Rs.500,000/month for 6 months and doesn't change. What do you think Ajay would do? He will undoubtedly walk away from the deal, and he would not purchase the land. You may be wondering why?

Cost of land = Rs.500,000/

Agreement Fee: Rs.100,000.

Total = Rs. 600,000/-

The land is valued at Rs.500,000/-

It is not sensible to purchase land worth Rs.600,000. Ajay has already paid 1lk so he can still purchase the land but will end up paying Rs 1lk more. Ajay will cancel the deal and let go of the Rs.100,000.00 agreement fee (which Venu clearly has).

I trust you have understood the transaction. If you don't, it is a good sign as you now know the basics of the call options. We will continue to examine the Ajay Venu transaction, but we won't rush to apply this to stock markets.

These Q&A's will help you understand the transaction better.

1. You wonder why Ajay would make such a wager when he knows that he will lose his 15,000 if land prices do not rise or stay flat.
   1. Agreed Ajay would be losing 1 lakh. But the best part about it is that Ajay already knows his maximum loss, which is 1 lakh. He doesn't have to worry about any negative surprises. His profits and therefore returns will increase as the land prices rise. He would make Rs.400,000/- profit from his Rs.100,000.00 investment, which is 400%.
2. What circumstances would Ajay's position make sense?
   1. This is the only scenario in which the land price rises.
3. What circumstances would Venu's situation make sense?
   1. Only in this scenario, the price of land falls or remains flat.
4. Venu seems to be taking a huge risk. Venu would be losing a lot of money, if land prices rise after six months.
   1. Think about it. Venu is a beneficiary of two of the three possible outcomes. Statistically, Venu's chances of winning the bet are 66.66%, compared to Ajay’s 33.33%.

Let's now summarize some important points.

• Venu pays Ajay the money. He has the right to cancel the deal, but Venu also has the obligation to honor Ajay’s claim if necessary.
• The price of the land determines the outcome of the agreement at termination (end-of-6 months). The agreement is worthless without the land.
• The agreement is called a derivative and land is an underlying.
• This agreement is known as an "Options Agreement".
• Venu, who has been paid an advance by Ajay, is now called the "agreement seller" or the "writer", while Ajay is the "agreement buyer".
• This agreement can also be called "an option agreement". Ajay is the Options Buyer, Venu is the Options Seller/Writer.
• The agreement is signed after 1 lakh has been exchanged. Therefore, 1 lakh is the cost of this option agreement. This amount is also known as the "Premium" amount
• Each variable of the agreement, including the area of the land, the price and the date for sale, is fixed.
• A thumb rule is that the buyer has a right in an option agreement and the seller has an duty

This example should be thoroughly reviewed. Please go back and review the example again to fully understand the dynamics. Please also remember this example as we will return to it on several occasions in the following chapters.

Now let's look at the same example from a stock market perspective.

1.3 -Understanding The call option

Let's now try to extrapolate this example into the stock market context, with the intention of understanding the 'Call Option. Note that I will not go into the details of option trades at this stage. Understanding the basic structure of a call option contract is the goal.

Let's say that a stock trades at Rs.67/day today. Today, you have the right to purchase the stock at Rs.67/- one month later. 75/-, but only if that share price is higher than Rs. Would you buy it at 75? This means that even though the share trades at 85, after one month you can still buy it for Rs.75

This is why you will need to pay Rs.5.0/- today to obtain this certificate. If the share price rises above Rs. 75), you have the right to exercise your rights and purchase shares at Rs. 75/- If the share price remains below Rs. 75/- You do not have to exercise your right and do not need the shares. You only lose Rs. In this instance, Rs. 5 is your loss. This arrangement is known as Option Contract.

There are only three possible outcomes after you sign this agreement. They are.

1. Stock prices can rise, for example Rs.85/-
2. Stock prices can fall, for example Rs.65/-
3. Stock prices can remain at Rs.75/-

Case 1 If the stock price rises, it makes sense to exercise your rights and purchase the stock at Rs.75/.

This is how the P&L might look.

The price at which stock can be bought = Rs.75

Premium paid =Rs. 5

The amount of expenses incurred is Rs.80

Current Market Price = Rs.85

Profit = 85-80 = Rs.5/.

Case 2 It doesn't make sense to purchase a stock at Rs.75/, as you would spend Rs.80/ (75+5) to get a stock on the open market at Rs.65/.

Case 3 If the stock remains flat at Rs.75/– it means that you are paying Rs.80/– to purchase a stock that is available at Rs.75/–, and you cannot invoke your right of buying the stock at Rs.75/–.

It's easy, right? This is the essence of a call option. The finer details of a call option are still unanswered. We will soon learn all about them.

This is the most important thing you need to know: Whenever you anticipate a stock's price (or any other asset) increasing, it makes sense to purchase a call option.

After we have covered the different concepts, let's now look at options and their terms
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Let me close this chapter by giving you a formal definition for a call option contract.

The buyer of the call option can buy an agreed quantity (the underlying) of a commodity or financial instrument from the seller at a specific time (the expiration) and for a specified price (the strike). If the buyer decides to buy the commodity or financial instrument, the seller (or "writer") will have to sell it. This right ". is granted to the buyer for a fee (called a "premium").
Details of "call option" will be discussed in the next chapter.

Keypoints

1. Options can be traded on the Indian market for more than 15 years. However, real liquidity is only available since 2006.
2. An Option can be used to protect your position and reduce risk
3. The buyer of the call option is entitled to and has an obligation to deliver the product.
4. Only one party can exercise the option (the buyer of an option).
5.    Option sellers can also be termed as Option writer.  
6. The option buyer must pay a predetermined amount to the option seller at the time of the agreement and this amount is termed as 'Premium amount'.
7. The agreement is reached at a pre-specified cost, commonly called the "Strike Price".
8. Only if the asset's price rises above the strike price, the option buyer will be able to benefit
9. The buyer doesn't benefit if the asset price remains below the strike. It is why it makes sense to always buy options when the price is expected to rise.
10. Statistics show that the option seller is statistically more likely to win in a typical option contract.
11. Otherwise, the option will be worthless.