There are two types of options available: the Call option and the Put option. These options can be bought or sold, and the choice made affects the profit and loss (P&L) profile. However, we will delve into the P&L profile later. For now, let’s focus on understanding the concept of a “Call Option” using a real-world example before applying it to the stock market.
Imagine a scenario where two individuals, Rahul and Arjun, are involved. Rahul is considering purchasing a 1-acre piece of land from Arjun. The land’s current value is Rs. 500,000/-. Rahul has received information that a new highway project will likely be approved near the land within the next 6 months.
If the highway project materialises, the land’s value will increase, resulting in a profitable investment for Rahul. However, if the information about the highway proves false and there are no plans for a highway in the future, Rahul will be left with a piece of land that has no value.
In this situation, Rahul is uncertain about whether he should buy the land from Arjun or not. While Rahul is contemplating, Arjun is willing to sell the land if Rahul is interested. To mitigate the risks, Rahul devises a unique arrangement that benefits both parties. Here are the details of the deal:
Now, who do you think is smarter in this agreement? Is it Rahul for proposing such a cunning arrangement, or Arjun for accepting it?
The answers to these questions can only be determined by conducting a comprehensive analysis of the agreement’s details. Let’s examine Rahul’s proposal in detail to gain a clearer understanding:
Both Rahul and Arjun must wait for 6 months to see what actually happens. Regardless of the outcome of the highway project, there are only three possible scenarios:
Once the highway project is implemented, the land price is expected to rise significantly, reaching ₹10,00,000. If the highway project doesn’t materialise, causing disappointment, the land price could plummet to ₹300,000. In case nothing significant happens, the price remains steady at ₹500,000. These three outcomes are the only possibilities.
Now, let’s put ourselves in Arjun’s position and analyse what he would do in each of these situations:
Scenario 1 – Price increases to ₹10,00,000:
Since the highway project aligns with Arjun’s expectations, the land price experiences a surge. As per the agreement, Arjun has the right to cancel the deal after six months. However, with the increased land price, it is unlikely that Arjun would cancel the deal. This is because the circumstances of the sale favour Arjun:
The current market price of the land: ₹10,00,000
Agreed sale price: ₹500,000
This means Arjun has the opportunity to purchase the land for ₹500,000, while its market value is much higher at ₹10,00,000. Arjun realises that this is an excellent deal and proceeds to demand that Rahul sells him the land. Rahul is obligated to sell the land at a lower price because he accepted the non-refundable agreement fee of ₹100,000 from Arjun six months earlier.
Now, let’s calculate Arjun’s profit:
Purchase Price: ₹500,000
Add: Agreement Fee: ₹100,000 (remember, this amount is non-refundable)
Total Expense: ₹500,000 + ₹100,000 = ₹600,000
Current Market Value of the land: ₹10,00,000
Hence, Arjun’s profit is ₹10,00,000 – ₹600,000 = ₹400,000.
Another way to view this is that Arjun is making four times the amount of money with an initial cash commitment of ₹100,000. Rahul, even though fully aware of the higher market value, is compelled to sell the land to Arjun at a significantly lower price. The profit Arjun makes (₹400,000) is equal to the notional loss incurred by Rahul.
Scenario 2 – The price of the land decreases to Rs. 300,000/-.
It turns out that the speculation about the highway project was false, and nothing substantial is expected to materialise. This disappointment leads to a sudden rush to sell the land, causing its price to drop to Rs.300,000/-.
So, what would Rahul do in this situation? Clearly, it wouldn’t make sense for him to purchase the land, so he would walk away from the deal. Here’s an explanation for the decision:
Remember, the sale price was fixed at Rs.500,000/- six months ago. Therefore, if Rahul were to buy the land, he would have to pay Rs.500,000/- plus the Rs.100,000/- agreement fees he had already paid. In effect, he would be spending Rs.600,000/- to acquire a piece of land worth only Rs.300,000/-.
Clearly, this would be illogical for Rahul. Since he has the right to call off the deal, he would simply choose not to buy the land. Here’s an important thing to note- Rahul has to forfeit the Rs.100,000/- agreement fee, which Arjun would pocket.
Scenario 3 – The price remains constant at Rs.500,000/-
For some reason, after six months, the price remains at Rs.500,000/- without any significant changes. What do you think Rahul would do? Well, he would obviously walk away from the deal and refrain from buying the land. Why, you may ask? Let’s consider the following calculations:
Cost of Land = Rs.500,000/-
Agreement Fee = Rs.100,000/-
Total = Rs.600,000/-
Value of the land in the open market = Rs.500,000/-
Clearly, it wouldn’t be logical to purchase the land for Rs.600,000/- when its market value is only Rs.500,000/-. Although Rahul has already committed Rs.100,000/-, he would end up paying an additional Rs.100,000/- if he proceeds with the purchase. Therefore, Rahul will call off the deal and, in the process, forfeit the Rs.100,000/- agreement fee (which Arjun will obviously retain).
I hope you have now clearly understood this transaction. If you have, that’s great news because through this example, you already understand how call options work! However, let’s not rush to conclude this to the stock markets just yet. We will spend more time exploring the Rahul-Arjun transaction.
What factors do you believe influenced Rahul’s decision to take the bet despite being aware of the potential loss of his 1 lakh if land prices remain stagnant or decrease?
Although Rahul would lose 1 lakh, the advantage is that he knows his maximum loss in advance. Therefore, there are no unexpected negative outcomes for him. Additionally, as the land prices increase, his profits and returns would also rise. At Rs.10,00,000/-, he would make a profit of Rs.400,000/- on his Rs.100,000/- investment, which is a 400% return.
Under what circumstances would a position like Rahul’s make sense?
Such a position would only make sense when the price of the land increases.
Under what circumstances would Arjun’s position make sense?
Arjun’s position would make sense only when the price of the land decreases or remains flat.
Why do you think Arjun is taking such a big risk? Wouldn’t he lose a lot of money if the land prices increase after 6 months?
Well, consider this: There are only three possible scenarios, and two of them favor Arjun. Statistically, Arjun has a 66.66% chance of winning the bet compared to Rahul’s 33.33% chance.