What is a Call Option and how it works in practice?

The derivatives segment of the market accounts for nearly 80 per cent of the Options market and rest is Futures. This clearly emphasizes the need to understand Options before trading. There are two types of Options: Call option and Put option. You can be a buyer or seller of these Options. Let us understand what the Call Option means with an example.

There are two friends Venu and Vijay. Venu has one acre of land priced at Rs5 lakh and he proposes to sell this to Vijay. News comes up that a highway project is likely to come up in the vicinity six months later which may appreciate the land value to Rs10 lakh. If this news is fake the land value is likely to depreciate. Venu puts forward an agreement proposal which is a win-win for both.

The details are as below

l Vijay needs to pay a fee of Rs1 lakh, which is non refundable

l Venu agrees to sell this land after six months at Rs5 lakh

l As Vijay has made a payment of only Rs1 lakh he can cancel the deal after six months, but Venu can't. If Vijay cancels he has to forego Rs1 lakh.

Six months later there would be three scenarios

Scenario 1

If the news of the highway project is true and the land value appreciates to Rs10 lakh. Vijay gets to make a profit of Rs4 lakh (Value of land is five plus one lakh advance, so 10-6= 4).

Scenario 2

If the price of the land falls down to Rs3 lakh then Vijay will lose only Rs1 lakh as he would drop the proposal to buy land. He has to shell down Rs5 lakh to buy a land which is costing only Rs3 lakh.

Scenario 3

For some reason if the land value remains the same Vijay will not buy the land. Cost of land is Rs5 lakh

Fee paid: Rs1 lakh

Total cost: Rs6 lakhs

Value of land: Rs5 lakhs

So he wouldn't go ahead with the deal.

From the above example we understand that Venu has the obligation to sell the land and Vijay has the right to buy or call off the deal. The fee which Vijay has paid is called the premium. Venu is the option seller and Vijay is the option buyer. Price is determined by the underlying asset which is land. Every variable like area of the land, price and the date of sale is fixed. Agreement is called a derivative. This is called an Options agreement. Now, let us understand from the stock market perspective.

Assume a stock is trading at Rs67. You have the right to buy the same one months later at Rs75. You would buy this only if the share is trading above Rs75. To get the buying rights you pay a premium of Rs5. An agreement or a contract of this type is known as a Call option.

There are three possibilities after a month. Stock price goes up to Rs85. Stock price goes down to Rs65. Stock price stays at Rs75.

Scenario 1

If stock price goes up to Rs 85 you would exercise your right to buy

Stock price Rs 75

Premium paid Rs 5

Cost Rs 80

Profit Rs 5

Scenario 2

Stock price Rs 65; Premium paid Rs 5 so, you would not exercise your right to buy a stock at Rs 75 (plus 5) when it is trading at 65.

Scenario 3

If the price remains flat at 75 also you would not exercise your right to buy as you have to pay Rs 80 when it is available at 75. So, whenever you expect the price of a stock to increase we buy a call option.

The following tabulated data helps us to get familiar with Option terminology.

I would like to conclude with the technical definition of an Option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or ‘writer’) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.

(The author is a homemaker, who dabbles in stock market investments in free time)­