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.
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.
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.
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:-
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.
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.
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.
Let's now summarize some important points.
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.
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.
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
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.