Now, let’s analyse the same example in the context of the stock market to enhance our comprehension of a ‘Call Option.’ It’s important to note that, for now, we will simplify the complexities of an options trade and concentrate on the fundamental structure of a call option contract.
Suppose a stock trade at Rs. 90/- per share. Today, you are allowed to buy the same stock one month later at a predetermined price of, let’s say, Rs. 100/- per share, but only if the share price on that day exceeds Rs. 100/-. Would you exercise this right? Of course! This means that even if the stock is trading at Rs. 120/- after one month, you can still purchase it at the lower price of Rs. 100/-.
To acquire this right, you need to pay a small amount today, let’s say Rs. 10/-. If the share price surpasses Rs. 100/-, you can exercise your right and buy the shares at the predetermined price. However, if the share price remains at or below Rs. 100/-, you do not need to exercise your right, and you only lose the initial payment of Rs. 10/-. This arrangement is known as an Option Contract, specifically a ‘Call Option.’
After entering into this agreement, there are three possible outcomes:
Price at which stock is bought = Rs. 100/-
Premium paid = Rs. 10/-
Total expense incurred = Rs. 110/-
Current Market Price = Rs. 120/-
Profit = Rs. 120 – Rs. 110 = Rs. 10/-
In this case, it does not make sense to buy the stock at Rs. 100/- because you would effectively spend Rs. 110/- (Rs. 100 + Rs. 10) for a stock available at Rs. 80/- in the open market.
If the stock stays at the same price, it means you would spend Rs. 110/- to purchase a stock available at Rs. 100/-. Therefore, you would not exercise your right to buy the stock at Rs. 100/-.
By now, you should have grasped the core logic of a call option. However, there are finer points that remain unexplained, which we will cover in subsequent lessons.
At this stage, it is crucial to understand the following: based on what we have discussed so far, it always makes sense to buy a call option when you anticipate an increase in the price of a stock or any other asset!
Now that we have covered the fundamental concepts, let us delve into options and familiarise ourselves with the associated terminology.
Here’s the exact formal definition of call options contract:
“The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right”.