Call Option Payoff Exploring the Seller’s Perspective

Throughout the course of this chapter, a symmetry in the P&L graph of an option seller has become apparent. We have concluded that there is a connection between the call option buyer and the seller. This is evident when plotting their respective gains and losses.

The call option seller’s P&L payoff appears to be a reflection of the call option buyer’s P&L benefit. The chart above makes it clear that the conversation we just had is accurate; you can see points such as…

1. The profit is limited to Rs. 9.25/- when the spot price trades below 3200.
2. From 3200 to 3215.75, the profits have been on a decline.
3. At 3215.75, it is clear that neither a gain nor a loss has been made.
4. At a spot level of 3215.75 and above, the call option seller begins to incur losses. The profit and loss chart shows that as the spot rate moves away from the strike price, their losses grow.

 – A note on margins

The risk exposure differs for a call option buyer and seller. The buyer has limited risk as they only need to pay the premium to the seller in exchange for the right to buy the underlying asset at a later date. It is important to note that their maximum loss is restricted to the premium paid.

When it comes to the risk profile of a call option seller, an unlimited loss potential exists; as the spot price moves higher than the strike, this risk increases. This creates a challenge for stock exchanges – how can they limit the exposure of such an option seller when faced with the possibility of enormous losses and prospective defaults?

Clearly, the stock exchange cannot accept such a large default risk from a derivative participant, thus the option seller must deposit funds as margins. This margin requirement for an option seller is similar to that for a futures contract.

– Putting things together

I hope the past four chapters have provided you with all the understanding necessary for purchasing and selling call options. Options are more complex than some other topics in finance, so it is advisable to summarise our learning whenever there is an opportunity and move on. Here are some of the key points to keep in mind with regard to buying and selling call options.

With respect to option buying

• If you’re optimistic about the underlying asset, buying a call option can be profitable upon expiry if its price surpasses the strike rate.

• The purchase of a call option is often referred to as holding a ‘Long Call’. This can also be known as being ‘long on a call option’.

• If you want to purchase a call option, it’s necessary to pay a premium to the person selling it.

• The call option buyer has limited exposure with just the premium to pay, but they have potential to make a potentially unlimited profit.

• The breakeven point is that moment where the call option buyer neither gains nor loses.

• P&L = Max [0, (Spot Price – Strike Price)] – Premium Paid

• Breakeven point = Strike Price + Premium Paid

With respect to option selling

• When you execute a call option (or write an option), the assumption is that, at expiration, the underlying asset’s value will not surge past the strike price.

• Instead of selling a call option, it can be referred to as ‘Shorting a call option’ or just ‘Short Call’.

• Selling a call option results in receiving the premium amount as income.

• The profit for an option seller is limited to the premium received, but the potential loss is unlimited.

• The breakdown point is the specific point at which the call option seller relinquishes all the premium earned, resulting in neither profit nor loss.

• Since a short option position carries unlimited risk, the seller must provide a margin deposit.

• Margins for short options are comparable to futures margins.

• The calculation for profit and loss (P&L) is: Premium – Maximum [0, (Spot Price – Strike Price)]

• The breakdown point is determined by adding the strike price and the premium received.

Other important points

• When you have a bullish view on a stock, there are several strategies you can employ: buying the stock in the spot market, purchasing its futures, or acquiring a call option.

• On the other hand, if you hold a bearish perspective on a stock, you have several options: selling the stock in the spot market (typically for intraday trading), shorting futures, or shorting a call option.

• The calculation of intrinsic value for a call option remains consistent, regardless of whether you are the buyer or the seller.

• However, the calculation of intrinsic value differs for a put option.

• The methodology for calculating net profit and loss (P&L) varies between the call option buyer and the call option seller.

• In the past four chapters, we have delved into P&L and its behaviour with expiration in mind, providing a more comprehensive understanding.

• It is not necessary to wait until option expiration to determine profitability.

• Much of option trading revolves around changes in premiums.

• For example, if I purchased a Mahindra 2050 call option at Rs. 6.35 in the morning and by noon it was trading at Rs. 9/-, I could decide to sell it and capture the profits.

• The premiums are constantly changing due to multiple factors; we will become more familiar with them as we continue through this module.

• Call option is usually shortened to ‘CE’, so the Mahindra 2050 Call option is also known as Mahindra 2050CE. This is because CE stands for ‘European Call Option’.