Two sides of the same coin
Let’s understand a with a context to the movie Deewar. Similiarly to the Deewaar brothers, these two parties are two sides of the same coin in Option trading. Unlike their counterparts however, making decisions based on market trends is more important than morality.
One thing to remember: whatever is the fate of the option seller, it impacts the opposite for the buyer. If one gains Rs 100/-, it automatically means that another loses it. A list of generalisations can be surmised from this:
To gain a better understanding of these concepts, it would be beneficial to examine the perspective of the option seller, specifically focusing on the Call Option in this chapter.
Before we move on, I want to caution you about this chapter – since the option seller and buyer are mirror images of each other, this section could appear repetitive of what we’ve just discussed in the last chapter. Therefore, it might give you the temptation to skim over it. I urge you not to do that and remain attentive for any slight variations which could have a massive influence on the P&L of the call option writer.
– Call option seller and his thought process
We discussed the ‘Rahul-Arjun real estate situation from chapter 1, analysing three potential outcomes that could bring the agreement to a reasonable conclusion.
It’s evident that selling options gives the writer an advantage – with only one out of three situations favouring the buyer. This alone can provide an incentive for someone to write options, but if they also possess strong market understanding, their prospects for success are even greater.
I should clarify that the possibility of making a profit through option selling relies solely on a natural statistical edge, and I don’t guarantee that it will turn out successful each time.
Let us now review the ‘Bajaj Auto’ case using the chart we looked at in the previous chapter.
The option writer arrives at the conclusion to sell a call option due to their thoughts on the future of Bajaj Auto’s price. Most importantly, they think that it won’t increase in the near-term, and selling the call option for its premium is a wise move.
Previously we discussed the significance of selecting the right strike price in options trading. As we continue through this module, we will take a deeper dive into this concept.
For the time being, let’s assume that the option seller has chosen to sell the 2050 strike option of Bajaj Auto and received a premium of Rs.6.35/-.
Let’s now go through the same exercise previously done to understand the Profit & Loss (P&L) profile of the call option seller, and make the essential generalizations. The idea of an intrinsic value of the option discussed in that chapter still applies here.
Before we move on to analyse the table, it is important to highlight that
Now that you are familiar with the table, let us take a closer look and make some generalisations, keeping in mind the strike price of 3000.
We can put these generalizations into an equation in order to calculate the potential profits or losses of a Call option seller.
P&L = Premium – Max [0, (Spot Price – Strike Price)]
Based on the formula mentioned above, let’s assess the profit and loss (P&L) for various potential spot values at expiration.
The solution is as follows –
Spot Price: 2980
P&L = 10.50 – Max [0, (2980 – 3000)]
= 10.50 – Max [0, -20]
= 10.50 – 0
Spot Price: 3050
P&L = 10.50 – Max [0, (3050 – 3000)]
= 10.50 – 50
Spot Price: 3025
P&L = 10.50 – Max [0, (3025 – 3000)]
= 10.50 – Max [0, 25]
= 10.50 – 25
We can observe that these results align with the generalisations mentioned earlier. The option seller’s profit is restricted to the extent of the premium received when the spot price is below the strike price. As the spot price moves above the strike price, the option seller incurs losses.
Let’s explore the P&L behaviour at and near the strike price to identify the point when the option writer starts incurring a loss.
The call option seller can generate a profit even if the spot price surpasses the strike price, as long as it remains below the strike price plus the premium received. This specific threshold is known as the “break-even point” for the call option seller.
Breakdown point for the call option seller = Strike Price + Premium Received
For example, for XYZ Company:
Breakdown point = 3000 + 10.50
The point at which the call option buyer reaches their breakeven point coincides with the breakdown point for the call option seller.