Basics of Derivatives Markets - Part 2

UNDERSTANDING CALL OPTION

Let us try to understand call option from our day to day to transaction. We have taken a real estate example as it makes it much easier to understand.

Call Option

Lets say today is Ist January and there is a person Mr A , who wants to buy property.

-       Mr. A goes to builder on 1^st January and paid  Rs 1 lakh.

-     Booked a house worth Rs 50 lakhs to be   purchased on 30 th March by making a balance payment.

There can be different scenarios on 30 the of March.

Scenario 1 on 30^th March

-       On 30^th March if property is worth Rs 30 lakhs only , what will Mr A do ?

OPTIONS with Mr A

1. Pay the balance amount & buy the house.

    - This means he is Exercising his right

2. Let his 1 lakh go and buy similar house at  Rs 30 lakhs.

- This means he is not exercising his right.

Obviously, Mr A will not exercise the option as it means that he will be buying a property worth 30 lakhs in 50 lakhs. And hence he will back out from the agreement and let his 1 lakh be forfeited.

Scenario 2 on 30^th March – Price of house is  70 lakhs

Mr A will pay the balance amount & buy the house.

    - Means he is Exercising his right

- Made a profit of Rs 20 lakhs.

- Builder made a loss of Rs 20 lakhs. He cannot refuse to sell as A has purchased Right to Buy.

How builder is loosing 20 lakhs ? 

IMPORTANT POINTS

    Mr. A                                                 Builder

House                                            Buyer                                                 Seller

Right                                             Buyer                                                 Seller

-          Mr. A has purchased right to buy .

-          By accepting Rs 1 lakh, Builder has sold the right.

-          Mr. A may or may not exercise the right. If it is beneficial to exercise the right only then Mr A will exercise. Otherwise he will not exercise and choose to get his 1 lakh forfeited.

Hence -

A call option is an option granting the right to the buyer of the option to buy the underlying asset on a specific day at an agreed upon price, but not the obligation to do so.

Hence call option is RIGHT TO BUY.

A call option can be bought and it can be sold.

Seller has granted this right to the buyer of the option. 

The person who has the right to buy the underlying asset is known as the “buyer of the call option”.

The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract- known as strike price.

Since the buyer of the call option has the right (but no obligation) to buy the underlying asset, he will exercise his right to buy the underlying asset if and only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract.

The buyer of the call option does not have an obligation to buy if he does not want to.

For daily view on nifty visit http://theoptionschool.blogspot.in/p/view-on-nifty.html