Call option and put option understanding types of options

The options marketplace offers two primary instruments: Call options and Put options. Market participants may assume either buying or selling positions, with each approach generating distinct profit and loss outcomes. Whilst we shall examine these financial profiles subsequently, our immediate focus centres on comprehending the mechanics of a “Call Option” through a practical illustration before transitioning to stock market applications.

Consider a transaction between two parties, Vikram and Suresh. Vikram contemplates acquiring a one-acre property parcel from Suresh, currently valued at Rs 6,00,000. Vikram has learnt that government authorities may approve a major motorway development near this location within six months.

Should the motorway materialise, property values would appreciate substantially, yielding considerable returns for Vikram. Conversely, if the motorway proposal proves unfounded, Vikram faces ownership of land offering limited appreciation potential.

Vikram remains undecided regarding this property acquisition from Suresh. Whilst Vikram deliberates, Suresh stands prepared to complete the transaction should Vikram proceed. To address the uncertainty, Vikram structures an innovative arrangement serving both parties’ interests. The terms include:

Vikram provides an initial payment of Rs 1,25,000 as a non-returnable contract fee

Suresh commits to transferring the property to Vikram following a six-month period

The transaction price remains fixed at today’s valuation of Rs 6,00,000

Having remitted the initial fee, Vikram alone retains authority to withdraw from the arrangement after six months, whilst Suresh cannot terminate the agreement

Should Vikram elect to withdraw, Suresh retains the initial payment

Which participant demonstrates superior judgement in this arrangement? Does Vikram’s proposal reflect greater acumen, or has Suresh made the shrewder choice?

These questions require thorough examination of the contractual framework. Let’s analyse Vikram’s proposal comprehensively:

Through the Rs 1,25,000 contract fee, Vikram creates a binding commitment from Suresh, who must reserve the property exclusively for Vikram throughout the six-month duration

Vikram establishes the purchase price at the current Rs 6,00,000 valuation, meaning irrespective of future market fluctuations, Vikram may acquire the property at this predetermined figure, having paid the additional Rs 1,25,000 today

Upon completion of six months, should Vikram decline to proceed, he possesses the right to reject the transaction, whilst Suresh, having accepted the contract fee, cannot oppose Vikram’s decision

The contract fee remains fixed and non-returnable under all circumstances

Both participants must await six months to observe actual developments. Regardless of the motorway outcome, three scenarios exist:

Following successful motorway implementation, property values may surge to Rs 12,00,000. Without the motorway development, disappointing market conditions could reduce values to Rs 3,50,000. Alternatively, absent significant developments, values might remain constant at Rs 6,00,000. These represent the exclusive possibilities.

Now, examining Suresh’s perspective and potential actions under each circumstance:

Scenario 1 – Valuation Rises to Rs 12,00,000:

The motorway development proceeds as Vikram anticipated, driving substantial property appreciation. Per the contractual terms, Vikram holds cancellation rights after six months. However, given the increased valuation, Vikram would certainly not withdraw. The transaction parameters favour Vikram considerably:

Current market valuation: Rs 12,00,000

Agreed purchase price: Rs 6,00,000

Vikram can therefore acquire property worth Rs 12,00,000 for merely Rs 6,00,000. Recognising this exceptional opportunity, Vikram would demand Suresh complete the sale. Suresh must honour the lower price, having accepted the non-returnable Rs 1,25,000 contract fee six months earlier.

Calculating Vikram’s gain:

Purchase expenditure: Rs 6,00,000

Contract fee: Rs 1,25,000 (non-returnable amount)

Total outlay: Rs 6,00,000 + Rs 1,25,000 = Rs 7,25,000

Current market valuation: Rs 12,00,000

Vikram’s profit therefore equals Rs 12,00,000 – Rs 7,25,000 = Rs 4,75,000.

Alternatively, Vikram achieves nearly quadruple returns on his Rs 1,25,000 initial commitment. Suresh, despite understanding the elevated market valuation, must complete the transaction at the substantially reduced price. Vikram’s Rs 4,75,000 gain directly corresponds to Suresh’s notional loss.

Scenario 2 – Valuation Decreases to Rs 3,50,000:

The motorway speculation proves baseless, with no substantial development anticipated. This disappointment triggers widespread selling pressure, depressing property values to Rs 3,50,000.

How would Suresh respond? Purchasing the property becomes entirely illogical, prompting withdrawal from the arrangement. Consider the reasoning:

The purchase price was established at Rs 6,00,000 six months previously. Proceeding would require Suresh paying Rs 6,00,000 plus the Rs 1,25,000 contract fee already remitted, totalling Rs 7,25,000 for property worth merely Rs 3,50,000.

This represents an unreasonable transaction for Suresh. Exercising his withdrawal right, he would decline the purchase. Note importantly: Suresh forfeits the Rs 1,25,000 contract fee, which Vikram retains.

Scenario 3 – Valuation Remains at Rs 6,00,000:

After six months, values remain unchanged at Rs 6,00,000. What action would Suresh take? He would withdraw and decline the acquisition. Why? Consider these calculations:

Property cost: Rs 6,00,000

Contract fee: Rs 1,25,000

Combined total: Rs 7,25,000

Open market valuation: Rs 6,00,000

Purchasing property for Rs 7,25,000 when market value stands at Rs 6,00,000 makes no sense. Although Suresh has committed Rs 1,25,000, proceeding adds another Rs 1,25,000 expense. Therefore, Suresh terminates the arrangement, forfeiting the Rs 1,25,000 contract fee (which Vikram retains).

Understanding this transaction thoroughly proves essential because this example demonstrates fundamental call option mechanics. Before progressing to stock market applications, let’s further examine the Vikram-Suresh arrangement.

Frequently Asked Questions:

What motivated Vikram’s decision despite knowing he might lose Rs 1,25,000 if property values stagnate or decline?

Whilst Vikram risks losing Rs 1,25,000, he benefits from knowing his maximum potential loss upfront, eliminating unexpected adverse outcomes. Moreover, rising property values generate proportionate profits. At Rs 12,00,000, he earns Rs 4,75,000 profit on his Rs 1,25,000 commitment, representing 380% returns.

When does Vikram’s position prove advantageous?

This position benefits Vikram exclusively when property valuations increase.

When does Suresh’s position make commercial sense?

Suresh benefits when property valuations decrease or remain unchanged.

Why would Suresh accept such substantial risk? Wouldn’t significant losses result from property appreciation after six months?

Consider this: Three possible outcomes exist, with two favouring Suresh. Statistically, Suresh holds 66.66% probability of favourable outcomes compared to Vikram’s 33.33% chance.

Key Takeaways:

Vikram’s payment to Suresh establishes a contractual framework where Vikram possesses termination rights whilst Suresh bears performance obligations should Vikram demand completion

The arrangement’s ultimate outcome depends entirely on property valuation at the six-month conclusion; the agreement holds no independent value without the underlying property

The property, forming the agreement’s foundation, constitutes the “underlying” asset, whilst the arrangement itself represents a “derivative” instrument

This particular structure is termed an “Options Agreement”

Having received Vikram’s advance payment, Suresh becomes the “agreement seller” or “writer,” whilst Vikram is the “agreement buyer”

In options terminology, Vikram represents the Options Buyer, whilst Suresh is the Options Seller/Writer

The Rs 1,25,000 payment establishes the option agreement price, termed the “Premium”

All agreement variables—property dimensions, price, and transaction date—remain fixed

Fundamentally, options agreements grant buyers rights whilst imposing obligations on sellers

Thoroughly comprehending this example proves crucial for understanding options mechanics

For those exploring equity investment opportunities through a stock broker or seeking guidance from a financial advisor, understanding these foundational concepts proves invaluable when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, options contracts represent sophisticated instruments within derivative markets.

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