Call Option Payoff Exploring the Seller’s Perspective

Call Option Seller Payoff

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:

The profit is limited to Rs 18.75 when the spot price trades below 2,850

From 2,850 to 2,868.75, the profits have been on a decline

At 2,868.75, it is clear that neither a gain nor a loss has been made

At a spot level of 2,868.75 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 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 an equity, there are several strategies you can employ: buying the equity in the spot market, purchasing its futures, or acquiring a call option

On the other hand, if you hold a bearish perspective on an equity, you have several options: selling the equity 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 Tata Motors 475 call option at Rs 12.50 in the morning and by noon it was trading at Rs 16.80, 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 Tata Motors 475 Call option is also known as Tata Motors 475CE. This is because CE stands for ‘European Call Option’

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding both buyer and seller perspectives proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, comprehending complete call option payoff structures enables more sophisticated investment strategies.

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