Are you familiar with the Bollywood movie 'Deewaar'? It was a superhit in 1975. The film gained cult status due to its famous dialogue 'Mere Paas Maa Hai'. The film is about two brothers who share the same mother. One brother is a righteous man and grows up to be a cop. The other brother is a notorious criminal with opposing views to his cop brother.
The reason I am talking about this movie is because the option buyer and the option writer are very similar. They are two sides of one coin. Unlike the Deewaar brothers, there is no morality to Options trading. Instead, the focus is on markets and what one can expect from the markets.One thing to keep in mind is that what happens to an option seller with respect to P&L will also happen for the option buyer. The option writer making Rs.70/day in profit automatically means the option buyer losing Rs.70/day.Below given a list-
These points can be appreciated further if you look at the Call Option through the eyes of the seller, which is the purpose of this chapter.
Before we begin, let me warn you about something. Because there is P&L harmony between the option seller (the buyer) and the option seller (the seller), the discussion in this chapter will be very similar to that in the previous chapter. You could therefore skip the entire chapter. to do this it's a bad idea. I suggest that you pay attention and notice the significant impact it has upon the P&L for the call option writer.
Remember the chapter 1 example of 'Ajay Venu' real property? We discussed three possible scenarios that could bring the agreement to a logical conclusion.
You will notice that the option buyer suffers a statistical disadvantage when buying options. This is only one of three possible scenarios for the buyer. The option seller benefits in 2 of the 3 scenarios. This is only one incentive for option writers to sell options. The chances of an option seller making a profit are high if they have a strong market understanding.
It should be noted that only the natural statistical edge has been discussed here and I am not saying that option seller will always be in profit side.
Let's continue with the 'Bajaj Auto" example from the previous chapter. Now let's build a case for a call options seller to see how he would react. Let me republish the chart.
As I have mentioned, choosing the right strike price in options trading is crucial. This will be discussed in more detail in the next module. Let's assume that the option seller sells Bajaj Auto 2050 strike option to collect Rs.6.35/ a premium. For more information, please refer to the option chain.
We will now go through the same exercise as in the previous chapter in order to better understand the P&L profile and make the necessary generalizations. This chapter will continue to use the concept of intrinsic value for the option we discussed in chapter 1.
Please note: Before we discuss the table,
You should now be familiar with the table. Let's take a look at the table and make some generalizations. (Do not forget that the strike price for this contract is 2050).
These generalizations can be used to calculate the P&L for a call option seller.
premium - Max
[0.(spot price - strike price)]
Let's use the formula above to evaluate the P&L and determine if there are any spot values that might be available at expiry.
Here's the solution:
= 6.35 – Max [0, 2023 - 20305]
= 6.35 - Max [0., -27]
= 6.35 - 0.
This is consistent with Generalization 1 (profit limited to the amount of premium received).
= 6.35 – Max [0, (2072-2050)]
6.35 - 22
Generalization 2 explains the answer. Call option writers would lose if the spot price rises above the strike price.
6.35 - Max [0., +5]
5.35 - 6.35
The spot price is still higher than the strike but the call option writer seems to still be making money. This goes against the 2 and generalization. This is due to the 'breakeven' concept that we discussed in the previous chapter.
Let's examine this further. We will look at the P&L behavior around and within the strike price to determine when the option writer will begin making losses.
The option writer makes money even if the spot price rises above the strike. He continues to make money until the spot price exceeds strike + the premium received. This is the breakpoint, where he begins to lose money.
Breakdown point of the call option seller = Strike price + Premium received
Bajaj Auto is an example.
= 2050 + 6.35
The breakeven point of a call buyer is the breakdown point of a call option seller.
As we've seen, there is great symmetry between the seller and buyer of call options. The same thing can be seen if you plot the P&L graph for an option seller. The same is true for -
The P&L payout of call option sellers looks almost identical to that of call option buyers. The following points are consistent with our discussion.
Consider the risk profile of the buyer and seller of call options. The risk is not on the call option buyer. The buyer of a call option only has to pay the premium amount to the seller. This would allow him to purchase the right to purchase the underlying at a later date. We know that his maximum loss (risk) is limited to the premium he already paid.
When we look at the risk profile of call option sellers, we see that there is an unlimitable risk. The spot price can rise above the strike price, increasing his potential loss. This being said, consider the stock exchange. What can they do to manage their risk exposure to an option vendor, given the possibility of losing a lot? What happens if an option seller experiences a large loss or defaults?
The stock exchange can't afford to allow a derivative participant such a large default risk. Therefore, it is compulsory for option sellers to keep some margins. An option seller will be charged margins similar to a futures contract.
This is the Zerodha Margin calculator snapshot for Bajaj Auto Futures and Bajaj Auto 2020 Call Option. Both expire on the 30th April 2015.
Here is the margin requirement to sell 2050 call options. (image 5)
You can see that the margin requirements for both options writing and trading futures are similar. There is a slight difference, but we will address it later. You should note, for now, that option selling involves margins similar to futures trades, and the margin amount is approximately the same.
I trust the four chapters that have just been completed will give you the information you need to buy and sell call options. Options are not as easy to understand as other topics in Finance. It makes sense to consolidate your learning and then move on. These are some key points to remember when selling and buying call options.
In relation to the option of buying
In relation to option selling
Other important information
When Indian option was first introduced, there were two options: American and European. All options for indexes (Nifty, Bank Nifty options), were European-based. The stock options were American. The main difference was in the 'Options Exercise'.
European Options If an option type is European, the buyer must wait until the expiry date in order to exercise his rights. Settlement is determined by the spot market value on the expiry date. If a buyer has purchased a Bajaj Auto 2050 call option, then the buyer must be more profitable than the breakeven point at expiry. The option will be worthless for the buyer, and he will forfeit all of the premium money he paid to Option sellers.
American Options-An American Option allows the buyer to exercise his right of purchase at any time during the expiry of the option. Settlement is determined by the spot market at that time and not dependent on expiry.Today, Bajaj Auto's spot market trades at 2030. There are still 20 days until expiry. He purchases the Bajaj Auto 2050 option call option. Bajaj Auto crosses 2050 on the next day. Baja Auto 2050 American Call Option buyer may exercise his right. The seller must agree to settle with the buyer. The expiry date is not important here.
You may be familiar with option and ask yourself this question: "Since we can nevertheless buy an option now, possibly in 30 minutes, after we have purchased it, what does it matter if it is American or European?"
You have a valid question. Let's think about the Ajay/Venu example. This is a European Option. Venu and Ajay were to re-examine the agreement after six months. Imagine if Ajay insists that he can come anytime during the agreement's tenure and claim his right (similar to an American Option) After they sign the agreement, there may be strong rumors about the highway project. A strong rumor causes land prices to rise and Ajay decides to exercise his right. Venu will then be legally obligated to deliver land to Ajay, even though it is clear that land prices have risen due to strong rumors. Venu is at risk of being 'exercised' any day, rather than the expiry date. Therefore, the premium Venu would require is higher to ensure he is compensated.
American options are therefore always more expensive than European options.
You might also be interested to learn that NSE eliminated the American option from its derivatives segment 3 years ago. All options in India now have European nature. This means that the buyer can exercise his option on the spot price at the expiry date.
Now, we will look at the "Put Options".