Buy call option A Beginner’s Guide to Call Buying

Previously, we discussed the groundwork for a call option and understood its general use. In this chapter, we will further explore the dynamics of a call option and become well-versed in both buying and selling it. Here’s a recap: 

1. If you anticipate that the underlying asset will go up in price, it is sensible to purchase a call option.
2. If the price doesn’t increase, or even decreases, then the purchaser of the call option will face a loss.
3. The buyer of the call option would incur a cost equal to the premium (agreement fees) they paid to the seller/writer.

Taking these three points into account will give us a better understanding of the call option.

• Understanding call option with a case study 

This chart suggests that it would make sense to purchase a call option. The graphic shows why investing in a call option could be beneficial.

Let’s assume Mahindra and Mahindra’s stock has dropped to its 52-week low, and I think it might be time to consider investing. I have a few thoughts about this possible trade which I will share with you.

1. Mahindra and Mahindra is a quality fundamental stock, there is no denying this.
2. I believe the significant decline in the stock price could be an overreaction by the market to the volatility in Mahindra’s business cycle. 
3. I anticipate that the downward trend in the stock price will soon come to a halt and eventually reverse. 
4. However, I am hesitant to purchase the stock for long-term holding at the moment due to concerns about further declines. 
5. Additionally, I am reluctant to buy Mahindra’s futures because I worry about potential mark-to-market losses. 
6. Nevertheless, I don’t want to miss out on the opportunity of a sharp reversal in the stock price.

Overall, my sentiment towards Mahindra’s stock price is positive in the long run. However, there is a possibility of short-term losses if the share price continues to remain weak, albeit the likelihood of this occurrence is relatively low. This puts me in a dilemma regarding the appropriate course of action to take.

Regarding my predicament, a call option on Mahindra is an obvious choice, due to reasons I will discuss shortly.

We can observe that the stock is at Rs.3137.5. I have invested in the 3150 call option with a premium of Rs.9.75/-. You may be asking why I’ve picked this strike price out of the multitude available. 

Strike price selection is a complex subject, and we will get into it later, but for now, let us just accept that 3150 is the correct one to purchase.

 – What would be the intrinsic value of a call option (upon expiry)

The call option will finish with one of three possibilities in the next 15 days: familiarity with these scenarios is likely.

Scenario 1 – The stock price surpasses the strike price, reaching 3180.

Scenario 2 – The stock price falls below the strike price, reaching 3120.

Scenario 3 – The stock price remains at 3150.

The 3 scenarios we discussed are comparable to those in Chapter 1; thus, it is assumed that you comprehend the P&L computation with the specific value of the spot indicated. 

Here’s an idea that needs to be explored: 

1. It is clear that when the expiry date for Mahindra approaches, three distinct possibilities exist for the price movement: an increase, a decrease, or unchanged.
2. Considering the scenario where the price is 3180, which is above the strike at 3150, what about other strikes in between, such as 3160, 3170, and 3175? Is it possible to make any generalisations about the potential profit and loss outcomes?
3. In scenario 2, the price is given as 3120, and this is below the strike of 3150. How do other strike prices – 3130, 3140, and 3145 – impact the P&L? Is there a generalisation that can be made?

I would like to refer to the possible prices of the spot (at the time of expiration) as the “Possible values of the spot upon expiration” in order to gain a better understanding of the profit and loss (P&L) for a call option.

To start, let’s explore the intrinsic value of the option at expiration. The intrinsic value of a call option upon expiry represents the non-negative amount that the holder can expect to receive if they choose to exercise it. In simpler terms, if you own a call option that has become profitable, what amount of money are you entitled to receive when it reaches its expiration? This can be expressed mathematically as:

IV = Spot Price – Strike Price

The intrinsic value of the 3150 Call option will be calculated if Mahindra is trading at 3175 on expiry in the spot market.

= 3175 – 3150

= 25

If Mahindra is trading at 3125 on the expiration date, here’s the intrinsic value of the option: 

= 3125 – 3150

= -25

Keep in mind, both a call or a put option‘s implied volatility must be non-negative; so we will maintain it at 3125.

= 0

We aim to consider the intrinsic worth of this option, calculate how much I will gain dependent on Mahindra’s expiry value and make some general conclusions about a call option purchaser’s profit and loss.