Discipline in Trading

September 2, 2022 by Bala gumber

To be a successful trader, you need a variety of skills. Maintaining discipline is a very crucial attribute that every trader must have, in addition to having the fundamental knowledge of the capital markets and the numerous technical features employed in trading. We’ve all read instances of traders who lost millions due to a lack of control or excitement. These incidents have caused the trading community to place more emphasis on this particular ability.

Meaning of Discipline in trading

When it comes to trading, the definition of discipline is rather straightforward. A trader receives several buy- and sell-side entries during the day. Before making any deal, a trader has or ought to have a set strategy in mind. Estimating the entrance price, the exit price, and a stop loss are all part of this plan. Giving in to watching these without a good reason could have deadly long-term effects.

Let's get to the Maths

Consider a trader who wants to purchase a stock at 100 with a goal of 103 and a stop loss of 98.5. If he is filled at 100 and the market drops to 98.5 after a while, he should immediately abandon the trade if there are no compelling reasons to do otherwise. The stock price may fall to 96 due to factors that a trader is unaware of if he holds it for a while in the belief that prices would return to 100 or 103.

By doing this, he is not adhering to the strategy. As a result, the trader is losing more money than he anticipated from that trade, which will have an impact on the rest of his trading. Price may return to 100 or 103, but such trading will not be beneficial over the long run.

The Correlation between Greed and Hope

Similar to how greed and hope may potentially wipe out his account. From the preceding illustration, the trader should book his profit if the call for that period is correct and the market rises to 103. A breach of discipline would also result from being overly optimistic and trying to hit 103.5 or 104, as the market might turn around from 103 and return to 100 by day’s end. The trader may not profit from being greedy even after making a correct call.

Fear: The Most expressive Emotion

The fear of losing is another area where a trader needs to improve. Just the fear of missing could cause a trader to get out of a position. Because of his lack of confidence in his abilities, he may then get out of a deal before the goal price or the stop loss price is reached. A trader should take action in response to such a worry and should not engage in any transactions about which he is uncertain.

The correlation between Major and Minor

A trader must invest their entire capital in their area of expertise and should regularly invest a little amount to experiment with new markets or trading techniques. If a trader with experience in the options market is drawn to the futures market by the potential returns, he must test the market first with a little amount that won’t affect his core trading before going all-in. Daily profit and loss objectives must also be followed and periodically evaluated. These characteristics will increase a trader’s consistency.

Trading With Discipline

Top traders exhibit unyielding discipline. John Hayden, a seasoned trader, writes that without discipline, it is impossible to control your ego, form empowering beliefs, have faith, and grow confident in your skills. The lack of discipline will stop your trading talent from developing. Although it may be tempting to trade impulsively, doing so will make it harder for you to achieve long-term financial success if you don’t create and adhere to clear-cut trading plans.

If you still make money after giving up your trading plan, what’s the harm? Even if you abandoned your trading plan, occasionally making a profit may give you short-term satisfaction, but making impulsive trade entries might harm your ability to exercise discipline over the long run. You are rewarded for a lack of discipline when you cease following your trading strategies, and you can start to think that doing so is not a huge concern. An unfair compensation might make you more likely to disregard trade intentions in the future. You can be prone to the thought, “I was rewarded once; perhaps I will be rewarded again.” I’ll venture a guess. However, the benefits of impulsive trading are frequently fleeting, and a lack of discipline ultimately leads to trading losses.

Making the distinction between justified and unjustified victories is helpful. When a trader creates a highly specific trading plan and adheres to it, the trade is justified. A successful trade is justifiable and strengthens discipline when it is executed according to a trading plan. When a trader doesn’t develop a plan or veers from the plan, an unjustified win ensues. He or she might receive a reward, but the result was random. The victory is unfair and could encourage impulsive trading.

Building discipline is essential for reliable and successful trading. In order to trade, you must make the law of averages work in your favor. It is possible to make an overall profit by repeatedly putting into practice tested trading techniques over a long period of time. It’s comparable to making shot after shot on the basketball court to reach the winning point total. You are more likely to score points the more shots you take. However, the player who first masters the ability to regularly make shots so that the ball is likely to go through the basket at every opportunity wins the game.

Consistency is crucial in a big way. Performance is haphazard if the player adopts one strategy at one point and a different strategy at a later one. The same holds true for trading. Trading consistently requires adhering to a predetermined trading strategy on each and every deal. This enables the law of averages to work in your favor so that you will ultimately turn a profit from the sequence of deals. The probability is thrown off if you stick to the plan occasionally and break it other times, and you’ll probably lose overall.

Profitability is a result of discipline. Don’t allow illegitimate victories to undermine your capacity for self-control. Follow your trading strategy, and emphasize the idea that you will be more successful in the long run if you do.

Steps to observe

Consistently adhere to your trading rules
Trading ahead of time
No promises or greed
Markets are not the best place to gamble; casinos are.
Remember, the market is always correct.
Fundamental and technical research
a balanced risk-to-reward ratio
Exchange your advantages
Learn new techniques occasionally, but with less frequency
periodic evaluation of your performance

Conclusion

A trader who has acquired solid technical and theoretical understanding is prepared to enter the world of capital markets. But these non-technical abilities, including as discipline and emotions, are as important to a trader’s success and must never be disregarded. Developing these skills will take years. Once obtained, it will be valuable for the rest of your life. Your goal of lucrative trading will undoubtedly be achieved through disciplined trading.

Aviation stocks all set to fly higher

September 1, 2022 by Bala gumber

Aviation stocks fly high as government lifts domestic airfare caps

ATF prices have also decreased during the past few weeks after reaching record highs.

On Thursday, after the Civil Aviation Ministry announced that domestic airfare limitations will be lifted, demand for aviation equities was high.

After around 27 months, the Union Aviation Ministry said on Wednesday that restrictions on domestic airfare would be lifted as of August 31.

InterGlobe Aviation’s stock rose from its opening price of 2,070.05 to a high of 2,080.80, an increase of 2.09% from its previous close.

SpiceJet Ltd. started trading at 46.05 before rising as much as 6.80% to 47.90 per share.

After carefully examining daily demand and air turbine fuel prices, it was decided to remove airfare caps. Aviation Minister Jyotiraditya Scindia stated on Twitter that “stabilization has taken hold and we are confident that the sector is prepared for development in domestic traffic in the near future.”

The Russia-Ukraine war, which started on February 24, has been a significant factor in the decline in ATF prices over the past three weeks after they spiked to record heights.

ATF cost 1.21 lakh rupees per kilolitre on August 1 in Delhi, which is around 14% less than it did the previous month.

After a two-month lockdown due to the COVID-19 pandemic, services resumed on May 25, 2020, with lower and maximum limits on domestic airfares based on flight times.

The Civil Aviation Ministry issued the following directive on Wednesday: “With effect from August 31, 2022,” it has been decided to abolish the fare bands that have been periodically advised on airfares. This decision was made after reviewing the existing status of scheduled domestic operations in relation to passenger demand for air travel.

Aviation stocks fly high as govt to lift domestic airfare caps from Aug 31

InterGlobe Aviation’s stock rose 2.09 percent over its previous closing after rising from Rs 2,070.05 to Rs 2,080.80 during the day.

On Thursday, after the Civil Aviation Ministry announced that domestic airfare limitations will be lifted, demand for aviation equities was high.

After around 27 months, the Union Aviation Ministry said on Wednesday that restrictions on domestic airfare would be lifted as of August 31.

InterGlobe Aviation’s stock rose 2.09 percent over its previous closing after rising from Rs 2,070.05 to Rs 2,080.80 during the day.

SpiceJet Ltd. started trading at Rs. 46.05 before rising as high as 6.80% to Rs. 47.90 per share.

“After carefully examining daily demand and air turbine fuel prices, it was decided to remove airfare caps (ATF). The market has stabilized, and we are confident that domestic traffic will increase in the near future “Jyotiraditya Scindia, the minister of aviation, stated on Twitter.

ATF prices have been declining in recent weeks after surging to record highs, largely as a result of the Russia-Ukraine war that started on February 24.

ATF cost Rs. 1.21 lakh per kilolitre on August 1 in Delhi, which is around 14% less than it did the previous month.

After a two-month lockdown due to the COVID-19 pandemic, services resumed on May 25, 2020, with lower and maximum limits on domestic airfares based on flight times.

The Civil Aviation Ministry announced in a directive on Wednesday, “With effect from August 31, 2022, it has been decided to remove the fare bands notified from time to time regarding the airfares after reviewing the current status of scheduled domestic operations in relation to passenger demand for air travel.”

Top Airline Stocks for Q3 2022

ATSG is the best for growth and performance, while GOL is the best for value.

Companies that provide a range of air transportation and travel services for passengers and freight make up the airline sector. Transportation by air, leasing of aircraft, hotel and automobile reservations, and trip management services are among the available options. Southwest Airlines Co., Delta Air Lines Inc., and United Airlines Holdings Inc. are some well-known names in the aviation sector.

Air travel was all but stopped by the COVID-19 epidemic. The effects of the pandemic are starting to dissipate, though, and it is roaring back. This year, more flights for both business and pleasure than before the outbreak.

The U.S. Global Jets ETF (JETS), an airline exchange-traded fund, represents airline companies, which have significantly underperformed in the overall market. Over the last 12 months, JETS has generated a total return of -25.6%, which is less than the total return of the Russell 1000 Index, which was 1.6%.

Here are the top three airline stocks in terms of performance, growth rate, and valuation. All statistics in the tables below and the market performance figures above are as of June 2, 2022.

Best Value Airline Stocks

These airline stocks had the lowest price-to-earnings (P/E) ratio over the past 12 months. Because dividends and share buybacks are two ways that earnings can be distributed to shareholders, a low P/E ratio indicates that you are paying less for each dollar of profit made.

Gol Linhas Aéreas Inteligentes SA and Gol Intelligent Airlines Inc. Brazil is the home of Gol Intelligent Airlines. Both business and leisure travelers can take use of its low-cost domestic and international airline services. The business also has a loyalty scheme. Paulo Kakinoff, the current chief executive officer (CEO), will leave his job and join the board of directors, according to a mid-May announcement from Gol. Starting on July 1, 2022, Vice President of Operations Celso Ferrer will take his place.
Air Transport Services Group Inc.: This company offers services for both freight and passenger air transportation as well as aircraft leasing. Additionally, it provides comparable services to both domestic and international airlines. Early in May, the company released its financial results for Q2 of its 2022 fiscal year (FY), which covered the three months that concluded on March 31, 2022. Compared to the same quarter last year, net earnings increased by 22.7% on an increase in revenue of 29.2%. The corporation said that all of its operations were at pre-pandemic levels.
Alaska Air Group Inc.: Alaska Air Group provides airline services through its subsidiaries Alaska Airlines and Horizon Air. Customers are served by the business throughout North America and Costa Rica along with its local partners.

Fastest Growing Airline Stocks

These are the top airline stocks according to a growth model that gives firms points based on a 50/50 weighting of their most recent quarterly YOY EPS growth and quarterly YOY percentage sales growth. The success of a corporation depends on both sales and profits. Due to this, evaluating businesses based on just one growth indicator leaves rankings open to accounting irregularities of the quarter (such as changes in tax law or restructuring charges), which could render one or both figures unrepresentative of the business as a whole. As outliers, businesses with quarterly EPS or revenue growth of greater than 2,500% were disqualified.
The company profile for Air Transport Services Group Inc. can be seen above.
Ryanair Holdings PLC: Ryanair Holdings is an ultra-cheap airline with its headquarters in Ireland. It offers point-to-point, short-haul flights across Europe and to a few locations in Africa and the Middle East. Ryanair did not have an EPS growth number in the table above because its EPS was negative.
SkyWest Inc.: SkyWest provides airline services through SkyWest Airlines, a subsidiary, and aircraft leasing services through SkyWest Leasing, a subsidiary. The business offers flights to locations around North America. Late in April, SkyWest released its financial results for Q2 FY 2022, which covered the three months ending March 31, 2022. Despite a 37.5% increase in revenue over the same quarter last year, net income dropped by 50.6%.

Airline Stocks with the Best Performance

Out of all the firms we looked at, these airline stocks had the best returns or the least drops in total return during the last 12 months.
Inc.

Air Transport Services: See the company described above.
Copa Holdings SA: Based in Panama, Copa Holdings offers passenger and freight air transportation services. The company operates regular flights to the Caribbean, Central, and South American nations, and vice versa.
Vuela Controladora Aviation company SAB de C.V.: Vuela Controladora Compaa de Aviación, usually referred to as Volaris, is a low-cost airline company located in Mexico that provides passenger air transportation. The organization primarily caters to cost-conscious businesses and vacationers heading to Mexico, the United States, and Central and South America. Late in April, Volaris released its financial results for Q1 FY 2022, which covered the three months that concluded on March 31, 2022. Despite an increase in revenue of 80.0%, the company’s net loss increased to $49 million from $36 million in the corresponding period last year. According to Volaris, rising fuel prices, which have increased since Russia’s invasion of Ukraine, are to blame for greater operating costs.

The views, opinions, and analyses shown here are for informative purposes only and should not be regarded as recommendations for individual investors to buy any particular security or use any particular investment strategy. Although we think the data shown here are trustworthy, we do not guarantee its correctness or comprehensiveness. The opinions and tactics we discuss in our content might not be appropriate for all investors. All views, opinions, and analyses in our content are given as of the date of publishing and are subject to change at any time because the market and economic situations are dynamic. The information is not meant to be a thorough examination of all relevant information pertaining to any particular nation, area, market, sector of the economy, investment, or strategy.

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Best Airline Stocks to Buy This Year

Don’t allow the rising cost of fuel and new COVID-19 concerns to scare you away from these aviation stocks.

It might seem odd to think about the best airline stocks to buy right now. Gas prices are soaring after being battered by the COVID-19 pandemic, with jet fuel prices rising by more than 126% in a year. The exchange-traded fund (ETF) tracking the airline sector, U.S. Global Jets ETF (ticker: JETS), fell 9.3% between April 18 and May 18. However, despite the epidemic and rising fuel prices, people still need and desire to fly, thus airline stocks can continue to prosper in the long run. The fact that airlines like Delta have reported relatively flat revenue despite a 120% sequential quarterly increase in COVID-19 cases this year, according to Morningstar analyst Burkett Huey “shows that, compared to previous quarters, consumer travel is significantly less susceptible to COVID-19. “These are eight of the greatest airline stocks to purchase for 2022 if you’re ready to endure some short-term setbacks in exchange for possible long-term gains.

Southwest Airlines Co. (LUV)

Southwest Airlines is the industry leader thanks to its excellent low-cost business model and strong bank sheet. The business has two key advantages over its competitors. First off, among the major American carriers, it has one of the finest credit ratings. At the end of 2021, it had around $12.5 billion in cash and cash equivalents on hand. Southwest did not have to significantly erode its equity or issue a significant amount of debt during the crisis. Because their stock prices haven’t yet recovered from pandemic-related losses, it’s simple to assume weaker competitors like American Airlines Group Inc. (AAL) are “cheap.”

United Airlines Holdings Inc. (UAL)

United Airlines reported first-quarter 2021 revenue of $7.6 billion. Huey claims that greater yield and capacity projections can offset the impact of higher oil prices to retain a fair value estimate of $57 per share, even if this is still 21% less than first-quarter revenue from 2019, before the pandemic. As the leading U.S. airline with the most worldwide focus, United may find it more challenging to recover from the epidemic than other domestic carriers.

However, Huey anticipates that this will benefit the airline as global traffic surges ahead into 2023. Huey continues, “We think United has considerably greater regulatory uncertainty than peer carriers due to its increased exposure to international travel, and we think summer 2022 will be a critical test of international travel recovery for United,” despite the fact that the airline seems to be on the rise.

Alaska Air Group Inc. (ALK)

Mid-sized airline Alaska Air has its main hub in Seattle. Prior to the pandemic, shares were selling for around $70 each, then for about $55 in the summer of 2021, and are currently worth about $47. This isn’t because ALK had a particularly rough time during the epidemic; rather, it’s because carriers like Americans had to take on more debt and dilution in order to survive. But it seems like the market is suddenly penalizing Alaska for its destinations.

Along with its namesake state, Alaska also provides considerable service to California and Hawaii. Due to severe local COVID-19 restrictions, markets like Hawaii have taken longer to recover. But at this time, the market might be ignoring ALK. Historically, the airline has had a management that is above average and well-run operations. While there will be a temporary weakness in tourist markets like Hawaii, ALK’s solid corporate culture should endure. Additionally, the airline is updating its fleet, which should result in significant fuel savings in the future.

Delta Air Lines Inc. (DAL)

One reason Delta is among the best airline stocks to buy now is simple: The company entered the pandemic with the strongest balance sheet of the big three legacy carriers. United Airlines’ financials were in merely average shape, while America was in the direst condition of the bunch. Coming out of the pandemic, Delta has a solid edge over United in terms of competitive positioning. United was arguably slow to add back flights at its key hubs. This gave ample room for discounters such as Southwest and JetBlue Airways Corp. (JBLU) to attack United at its main bases of operation.

In contrast, Delta has expanded its market share in Los Angeles, kept a firm hold on New York, and operates a virtual empire out of Atlanta. Huey asserts that Delta outperformed the most recent FactSet sales estimate by 6.5% and has been successful in passing along the increase in fuel prices and pay inflation to consumers. Delta has a good chance of restoring pre-pandemic levels of prosperity among the major three legacy carriers.

CONCLUSION

Due to limited studies, on the study of fluctuation of the stock price in the aviation industry for pre and post-Covid – 19. The present study explored that Covid – 19 has influenced the stock price of Aviation industries in India. Post-Covid – 19 has influenced drastically the aviation industries. The stock prices of 5 aviation industries have extremely become low due to the influence of Covid -19. If this situation continues, it becomes for all the industries to recover from the effect of Covid – 19. The main conclusion of this is to state the influence of Covid19 on the Aviation Sector and also give useful information about the stock price volatility to investors. Investors are advised to create a hedging policy, to mitigate this black swan event.

Further, the results of the study would be beneficial to the market participants, who buy or sell, or hold the stock of the aviation sector. At the same time, policymakers must take necessary steps to eradicate the pandemic disease Covid – 19. Investors are urged to develop a hedging strategy to lessen the impact of this black swan event. The study’s findings would also be helpful to market participants who purchase, sell, or hold aviation industry stocks. Politicians must simultaneously take the required actions to end the pandemic sickness. Covid – 19

Buying put option

August 4, 2022 by Bala gumber

Options

• Basics of call options
• Basics of options jargon
• How to buy a call option
• How to buy/sell call option
• Buying put option
• Selling put option
• Call & put options
• Greeks & calculator

• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega

5.1 – Getting the orientation right

I hope you’ve finished thinking about the call option’s realities from both the sellers’ and buyers’ points of view. If you are familiar with call options, it will be quite simple for you to grasp “put options.” From the standpoint of the buyer, the only difference between a put option and a call option is that the put option buyer should have a negative opinion of the markets as opposed to an optimistic view.

The purchaser of the put option is placing a wager that the stock price will decline (by the time expiry approaches). He, therefore, gets into a Put Option arrangement in order to profit from this viewpoint.

No matter where the underlying stock is trading, the buyer of a put option can purchase the right to sell a stock at a price (the striking price) under a put option agreement.

Keep in mind this generalization: Since the seller of the option expects the exact opposite of what the buyer does, there is a market. A market cannot exist if everyone has the same expectations. Therefore, the put option seller would anticipate a rise in the market (or a flattening of the stock) if the put option buyer anticipates a decline by expiration.

At a set price (the strike price), a put option buyer purchases the put option writer’s right to sell the underlying. This indicates that if the “put option buyer” is selling the put option seller, he will have to buy at expiration. Keep in mind that the put option seller is actually selling the put option buyer a right to “sell” the underlying to the “put option seller” at the time of expiration at the time of the agreement.

Confusing? Consider the “Put Option” as a straightforward agreement between two parties to conduct a transaction based on the price of an underlying –

The parties involved in a contract are referred to as the “contract buyer” and the “contract seller,” respectively.
The contract buyer invests money and purchases a right for himself.
The contract seller accepts the premium and commits to the deal.
On the day of expiration, the contract buyer will choose whether or not to exercise his right.
The contract seller is bound to purchase the underlying from the contract buyer if the contract buyer decides to exercise his right and sells the underlying (which may be a stock) at the agreed-upon price (the striking price).
Since the contract the buyer holds allows him to sell the underlying at a much higher price to the contract seller when the same underlying is trading at a lower price in the open market, it stands to reason that the contract buyer will only exercise his right if the underlying price is trading below the strike price.

Still perplexing? Do not be alarmed; an example will be used to help you better comprehend this.

Take into account the following scenario between the Contract seller and the Contract buyer:

Consider that Reliance Industries is currently trading at Rs. 850.
The contract buyer pays the contract seller Rs. 850 for the opportunity to purchase Reliance when it expires.
The contract buyer must pay a premium to the contract seller in order to secure this entitlement.
The contract seller will agree to purchase Reliance Industries shares at Rs. 850 a share in exchange for the premium, but only if the contract buyer wants him to purchase them from him.
For instance, if Reliance is trading at Rs. 820 upon expiration, the contract buyer may demand that the contract seller purchase Reliance from him for Rs. 850.
This indicates that the contract buyer can earn from selling Reliance for Rs. 850/- even if it is currently trading at Rs. 820/- on the open market.
It makes no sense for the contract buyer to exercise his right and ask the contract seller to acquire the shares from him at Rs. 850/- if Reliance is trading at Rs. 850/- or more upon expiration (let’s say Rs. 870/-). Given that he can sell it for more money on the open market, this is rather clear.
A “Put option” is a contract of this type that grants the buyer the right to sell the underlying asset when it expires.
Due to his sale of the contract buyer’s Reliance 850 Put Option, the contract seller will be required to purchase Reliance at Rs. 850.

I hope the discussion above has provided you with the necessary introduction to put options. It’s okay if you’re still unclear because as we move forward, I’m sure you’ll become more understandable. However, there are three crucial things you should know right now:

The put option’s seller is neutral or optimistic about the underlying asset, whereas the put option’s buyer is gloomy about it.
When the put option expires, the buyer has the opportunity to sell the underlying asset for the strike price.
Due to receiving an upfront premium, the put option seller is required to purchase the underlying asset from the put option buyer at the strike price.

5.2 – Building a case for a Put Option buyer

Let’s construct a real-world scenario to grasp the put option better, just like we did with the call option. We will first discuss the put option from the buyer’s standpoint before comprehending the put option from the seller’s standpoint.

Here are some of my opinions regarding Bank Nifty:

Trading for Bank Nifty is at 18417.
A week ago Bank Nifty encountered resistance at 18550. (resistance level highlighted by a green horizontal line)
Since there is a price action zone at this level that is evenly spaced in time, I view 18550 as resistance (for those unfamiliar with the notion of resistance, I recommend reading about it here).
The price action zone has been indicated with blue rectangle boxes.
The RBI maintained the status quo on the monetary rates on April 7th (yesterday), leaving the major central bank rates unchanged (as you may know RBI monetary policy is the most important event for Bank Nifty)
Therefore, given the technical resistance and lack of a significant fundamental trigger, banks may not be the trend in the markets this year.
Therefore, traders could choose to sell banks and purchase something else that is in demand at the moment.
I have a bearish leaning toward Bank Nifty because of these factors.
Since the market is bullish overall and just the banking sector is bearish, shorting futures may be rather dangerous.
Using an option is best in these situations, thus purchasing a Put Option on the Bank Nifty may make sense.
Keep in mind that if you purchase a put option, you profit if the underlying declines.

With this justification, I would rather purchase the 18400 Put Option, which is currently trading at a premium of Rs. 315. Remember that in order to purchase this 18400 Put option, I must pay the necessary premium (in this example, Rs. 315/-), which will be paid to the 18400 Put option seller.

The simplest way to purchase a put option is to phone your broker and ask him to do it for you in a matter of seconds. The put option can be purchased for any stock and strike. As an alternative, you can purchase it directly via a trading platform like Zerodha Pi. Later on, we will discuss the specifics of purchasing and selling options using a trading terminal.

It would be fascinating to watch the Put Option’s P&L behavior at expiration, presuming I had purchased Bank Nifty’s 18400 Put Option. We can even draw a few conclusions from this procedure regarding the P&L behavior of a Put option.

5.3 – Intrinsic Value (IV) of a Put Option

We must comprehend how to calculate a Put option’s intrinsic value before we can generalize the Put option P&L’s behavior. I’ll assume you are familiar with the idea of intrinsic value since we discussed it in the previous chapter. The intrinsic value of an option is the amount of money the buyer would be entitled to upon the expiration of the option.

A put option’s intrinsic value is calculated significantly differently than a call option’s intrinsic value. I’ll provide the call option’s intrinsic value formula here so you can see the differences.

Spot price minus strike price is the IV (call option).

A put option’s intrinsic value is –

IV (Put Option) = Spot – Strike Price

The formula we just looked at to determine an option’s intrinsic value is only applicable on the day the option expires. The intrinsic value of an option is, however, determined differently across the series. Naturally, during the expiry, we will comprehend how to determine (and the necessity of calculating) an option’s intrinsic worth. But for the time being, all that we need to know is how to calculate the intrinsic value at expiration.

5.4 – P&L behavior of the Put Option buyer

Let’s attempt to create a table that will help us determine how much money I, the buyer of Bank Nifty’s 18400 put option, would make under the various potential spot value changes of Bank Nifty (in the spot market), keeping the concept of intrinsic value of a put option at the back of our minds. Keep in mind that Rs 315 was paid as the premium for this choice. The fact that I paid Rs. 315 will not change, regardless of how the spot value increases. This is the price I paid to purchase the Bank Nifty 18400 Put Option.

Let’s examine the P&L’s behavior and make some observations (and also make a few P&L generalizations). Set your gaze at row number 8 to serve as your reference point for the conversation above.

Buying a put option is done in order to profit from a declining price. As we can see, the profit rises as and when the spot market price falls (with reference to the strike price of 18400).

1. Generalization 1: Whenever the spot price falls below the strike price, buyers of put options benefit. In other words, only purchase a put option if you believe the underlying asset will decline.

2. The strategy begins to lose money as soon as the spot price exceeds the strike price (18400). The loss is however limited to the amount of the premium paid, in this instance Rs. 315.

Generalization 2: When the spot price exceeds the strike price, the buyer of a put option incurs a loss. The maximum loss is nevertheless limited to the amount of the put option buyer’s premium.

Here is a common formula you can use to determine your profit and loss from a put option transaction. Keep in mind that this calculation applies to positions maintained until expiration.

Max (0, Strike Price – Spot Price) = P&L – Paid Premium

Let’s choose 2 random values to test the validity of the formula:

16510
19660

@16510 (spot below the strike, the position has to be profitable)

= Max (0, 18400 -16510)] – 315

= 1890 – 315

= + 1575

@19660 (spot above strike, the position has to be loss-making, restricted to the premium paid)

= Max (0, 18400 – 19660) – 315

= Max (0, -1260) – 315

= – 315

Clearly, both findings are in line with what was anticipated.

We also need to comprehend how a Put Option buyer calculates the breakeven point. Because we discussed breakeven points in the previous chapter, I’ll take the liberty of omitting an explanation here. Instead, I’ll just give you the formula to figure it out:

Strike Price – Premium Paid = Breakeven Point

To the Bank, It would be a neat breakeven point if

= 18400 – 315

= 18085

In accordance with this interpretation of the breakeven point, the put option should therefore be neutral at 18085. Please use the P&L formula to verify this.

= Max (0, 18400 – 18085) – 315

= Max (0, 315) – 315

= 315 – 315

The outcome is unmistakably consistent with what was anticipated at the breakeven point.

Note: The intrinsic value, P&L, and breakeven point are all calculated with regard to the expiry. We have assumed throughout this module that you, as the option buyer or seller, will set up the option trade with the purpose of holding it until expiration.

However, you will soon come to the realization that you will frequently start an options transaction only to close it well before expiration. In this scenario, calculating the breakeven point may not be as important as calculating the P&L and intrinsic value, which can be done using a different formula.

Let me make two assumptions about the Bank Nifty Trade so that I can explain this more clearly. We know the trade was initiated on April 7, 2015, and it expires on April 30, 2015.

What would the P&L be if the spot were at 17,000 on April 30th, 2015
What would the P&L be if the spot were at 17000 on April 15th, 2015? (or for that matter any other date apart from the expiry date)

The first question has a reasonably simple answer because we can immediately use the P&L formula.

= Max (0, 18400 – 17000) – 315

= Max (0, 1400) – 315

= 1400 – 315

= 1085

Moving on to the second question, the P&L won’t be 1085 if the spot is at 17000 on any date other than the expiration date; instead, it will be greater. At the right time, we’ll go over the reasons why this will be higher, but for the moment, just remember this.

5.5 – Put option buyer’s P&L payoff

We should be able to see the generalizations we’ve made about the Put option buyers’ P&L if we connect the P&L points of the Put Option and create a line chart.

You should take note of the following from the preceding chart; keep in mind that the strike price is 18400:

Only when the spot price exceeds the strike price does the buyer of the Put option suffer a loss (18400 and above)
However, this loss is only as great as the premium that was paid.
When the current price falls below the strike price, the put option buyer will profit exponentially.
The potential rewards are limitless.
You can see that the P&L graph simply transitions from a loss-making condition to a neutral situation at the breakeven point. Only above this level would the put option buyer begin to profit. The buyer of the put option does not profit or lose money at the breakeven point (18085).

CONCLUSION

When you are pessimistic about the prospects of the underlying, you should buy a put option. In other words, a Put option buyer only makes money when the value of the underlying drops.
When compared to the intrinsic value calculation of a call option, the intrinsic value computation of a put option is slightly different.
The strike price minus spot price is IV (Put Option).
P&L = [Max (0, Strike Price – Spot Price)] can be used to compute the profit and loss of a buyer of put options. – Paid Premium
Strike – Premium Paid is the formula used to determine the put option buyer’s breakeven point.

How to buy/sell call option

October 4, 2022August 3, 2022 by Bala gumber

Options

• Basics of call options
• Basics of options jargon
• How to buy a call option
• How to buy/sell call option
• Buying a put option
• Selling put option
• Call & put options
• Greeks & calculator

• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega

4.1 – Two sides of the same coin

Do you recall the 1975 Bollywood blockbuster “Deewaar,” which became cult-famous for its infamous “Mere pass maa hai” dialogue? Two brothers from the same mother are the subject of the film. While one brother, who is morally upright, develops into a police officer, the other brother ends up being a notorious criminal with very different values from his cop brother. The fact that the option writer and the option buyer are somewhat akin to these brothers is the reason I’m bringing up this venerable film right now. They are the two sides of the same coin. Of course, unlike the Deewaar brothers, there is no view on morality when it comes to Options trading; rather the view is more on markets and what one expects out of the markets. However, there is one thing that you should remember here – whatever happens to the option seller in terms of the P&L, the exact opposite happens to the option buyer and vice versa. For example, if the option writer is making Rs.70/- in profits, this automatically means the option buyer is losing Rs.70/-.

A brief list of these generalizations is below:

Option seller has limited profit if option buyer has a limited risk (to the degree of premium paid) (again to the extent of the premium he receives)
Option seller may be exposed to endless risk if option buyer has an unlimited possibility for profit.
The moment at which the option buyer begins to profit is as the breakeven point, and it is also the point at which the option writer begins to lose money.
If the option buyer is profitable by Rs. X, it follows that the option seller is losing Rs. X.
If the option buyer is losing X, it follows that the option seller is profiting X as well.
Last but not least, if the option buyer believes that the market price will rise (more specifically, above the strike price), the option seller will believe that the market will remain at or below the strike price, and vice versa.

The goal of this chapter is to examine the Call Option from the seller’s perspective in order to better understand these issues.

I have to warn you about this chapter before we move on because the discussion that follows in this chapter will be very similar to the discussion we just had in the previous chapter because there is P&L symmetry between the option seller and the buyer. As a result, you might be able to skip this chapter entirely. Please refrain from doing that; instead, I advise you to be vigilant so you can spot the subtle difference and the significant influence it has on the call option writer’s P&L.

4.2 – Call option seller and his thought process

Remember the real estate example “Ajay-Venu” from chapter 1? We considered three situations that would bring the agreement to a logical conclusion.

The land’s cost rises above Rs. 500,000. (good for Ajay – option buyer)
The cost remains constant at Rs. 500,000. (good for Venu – option seller)
The cost drops below Rs. 500,000. (good for Venu – option seller)

If you’ve seen, the option buyer has a statistical disadvantage when buying options because only one of the three possible outcomes is advantageous to the option buyer. In other words, the option seller wins in 2 of the 3 possible outcomes. One of the incentives for the option writer to sell options is simply this.

Please note that I am not implying that an option seller will always profit; rather, I am merely discussing a natural statistical edge.

However, let’s use the identical “Bajaj Auto” example from the previous chapter to make a case for a call option seller and comprehend his perspective on the same circumstances.

The stock has suffered severe losses, and it is obvious that sentiment is very low.
Given how far the stock has fallen, many investors and traders are likely to be in hopeless long positions.
Any increase in the stock price will be as a chance to get out of stranded long positions.
In light of this, there is minimal likelihood that the stock price would rise quickly, especially in the near future.
Selling the Bajaj Auto call option and collecting the premium can be as a favorable trading opportunity since it is anticipated that the stock price won’t rise.

The option writer decides to sell a call option after having these ideas. The key thing to remember is that the option seller is selling a call option because he doesn’t think Bajaj Auto’s price will rise very soon. As a result, he thinks selling the call option and getting the premium is a wise move.

Choosing the proper strike price is a crucial part of options trading, as I discussed in the last chapter. As this subject progresses, we will get into more information regarding this. Let’s assume for the time being that the option seller chooses to sell the 2050 strike option for Bajaj Auto and receive Rs. 6.35 as premiums.

To comprehend the P&L profile of the call option seller and to draw the necessary generalizations in the process, let’s repeat the exercise from the previous chapter.

Please take note of the following before we discuss the table above:

A cash inflow (credit) to the option writer is shown by the positive sign in the “premium received” column.
Regardless of whether a call option is purchased or sold, the intrinsic value of the option (upon expiration) is constant.
The basis for an option writer’s net P&L computation differs slightly.

1. An option seller obtains a premium (for instance, Rs. 6.35) when he sells options. Only after he had lost the entire premium would he have suffered a loss. In other words, if he loses Rs. 5 after obtaining a premium of Rs. 6.35, that means he is still in the black by Rs. 1.35. Therefore, in order for an option seller to incur a loss, he must first forfeit the premium that he has already received; any sum of money that he loses above the premium received will constitute his actual loss. The P&L calculation would be “Premium – Intrinsic Value” as a result.

2. The option buyer is also subject to the same defense. The P&L calculation would be “Intrinsic Value – Premium” since the option buyer must first recoup the premium he has already paid. As a result, the option buyer would be profitable above and beyond the premium amount he has received.

You ought to be familiar with the table above by now. Let’s examine the table and draw some conclusions (remember that the strike price is 2050) –

The option seller will profit, that is, he will keep the entire Rs. 6.35 premium, so long as Bajaj Auto remains at or below the strike price of 2050. Please take note that the profit stays at Rs. 6.35.

1. Generalization 1: As long as the spot price is at or below the strike price, the call option writer makes a maximum profit equal to the premium received (for a call option)

2. When Bajaj Auto begins to climb over the 2050 strike price, the option writer will lose money.

Generalization 2: As and when the spot price rises over the strike price, the call option writer begins to lose money. The loss increases when the current price deviates further from the strike price.

3. It is reasonable to infer from the aforementioned two assumptions that the option seller may have both unlimited profit potential and limited profit potential.

These generalizations can be used in a formula to determine the profit and loss of a call option seller:

P&L is equal to Premium minus Max [0, (Spot Price – Strike Price)]

Let’s examine the P&L for a few potential spot values on expiry using the formula above:

2023
2072
2055

The answer is as follows:

@2023

= 6.35 – Max [0, (2023 – 2050)]

= 6.35 – Max [0, -27]

= 6.35 – 0

= 6.35

The resolution fits Generalization 1 (profit restricted to the extent of the premium received).

@2072

= 6.35 – Max [0, (2072 – 2050)]

= 6.35 – 22

= -15.56

The solution fits Generalization 2. (Call option writers would experience a loss as and when the spot price moves over and above the strike price)

@2055

= 6.35 – Max [0, (2055 – 2050)]

= 6.35 – Max [0, +5]

= 6.35 – 5

= 1.35

The call option writer appears to be making money even if the spot price is greater than the strike.

Contrary to the second generality, this. This is due to the idea of the “breakeven point,” which we covered in the last chapter, as you are no doubt aware at this time.

Let’s investigate this further and observe the P&L activity towards the strike price to see precisely when the option writer will begin to lose money.

It is obvious that the option writer still benefits even when the spot price rises above the strike; in fact, he benefits until the spot price exceeds the strike plus the premium received. He now begins to lose money, hence it makes sense to refer to this as the “breakdown point.”

For the call option seller, the breakdown point is: Strike Price + Premium Received

In the case of Bajaj Auto,

= 2050 + 6.35

= 2056.35

As a result, the breakdown point for the seller of call options becomes the breakeven point for the buyer of call options.

4.3 – Call Option seller pay-off

The call option buyer and seller exhibit considerable symmetry, as we have observed throughout this chapter. In fact, if we display the P&L graph of an option seller, the same pattern may be seen.

The P&L payoff of the call option seller resembles the P&L payoff of the call option buyer. The following points, which are consistent with our recent discussion, can be seen in the graphic above:

As long as the spot price is trading at any price below the strike of 2050, the profit is capped at Rs. 6.35.
In the period from 2050 to 2056.35 (breakeven price), we can observe that earnings are declining.
We can observe at 2056.35 that there is neither a profit nor a loss.
The call option seller begins to lose money above 2056.35. In reality, the P&L line’s slope plainly shows that losses begin to rise when the spot value deviates from the strike price.

4.4 – A note on margins

Consider the risk tolerance of both the call option seller and the buyer. The buyer of a call option assumes no risk. He only needs to give the call option seller the requisite premium amount, in exchange for which he would purchase the right to purchase the underlying at a later time. His risk (maximum loss), as far as we are aware, is only as great as the premium he has already paid.

However, when you consider a call option seller’s risk profile, you see that he carries a limitless risk. As and when the spot price rises above the strike price, his potential loss could grow. Having stated that, consider the stock exchange. How can they control an option seller’s risk exposure given the possibility of “infinite loss”? What if the option seller decides to default because the loss is so significant?

It is obvious that the stock exchange cannot afford to allow a derivative player to carry such a high default risk, so the option seller must set aside some cash as margins. The margin required for a futures transaction and the margin charged to an option seller is comparable.

Here is a screenshot of the Zerodha Margin Calculator for the 30th April 2015 expiration dates of the Bajaj Auto Futures and Bajaj Auto 2050 Call Option.

As you can see, both situations have somewhat comparable margin requirements (option writing and trading futures). There is a slight distinction, of course; we’ll address it later. For the time being, I merely want you to be aware that selling options require margins somewhat akin to trading futures, and that the margin requirement is nearly equivalent.

4.5 – Putting things together

I believe the last four chapters have provided you with all the information you require to buy and sell call options. Options are a little more complicated than other financial issues. So I suppose it makes sense to reinforce our learning whenever possible before moving on. The following are the most important points to keep in mind while purchasing and selling call options.

In relation to buying options

Only when you are optimistic about the underlying asset should you buy a call option. The call option will only be lucrative at expiration if the underlying has risen above the strike price.
Purchasing a call option is often known as going long on the option or just going “long call.”
You must pay the option writer a premium in order to purchase a call option.
The call option buyer’s risk is constrained (to the amount of the premium paid) and his or her potential profit is limitless.
The breakeven point is the moment at which the buyer of a call option neither profits nor loses money.
Max [0, (Spot Price – Strike Price)] = P&L – Paid Premium
The strike price plus the premium paid is the breakeven point.

In relation to selling options

When you sell a call option (also known as options writing), you must be certain that the underlying asset won’t rise over the strike price when it expires.
Shorting a call option, or just “Short Call,” refers to selling a call option.
The premium amount is received when you sell a call option.
An option seller’s profit is limited to the premium he receives, while his loss is theoretically limitless.
The breakdown point is the point at which the seller of a call option forfeits all of the premium earned, meaning he is neither profiting nor losing money at that time.
He must put money down as a margin because the risk of a short option position is infinite.
The margins for short options are comparable to the margin for futures.
P&L is equal to Premium minus Max [0, (Spot Price – Strike Price)]
Strike Price + Premium Received is the breakdown point.

Additional crucial points

When a stock is in your favor, you have three options: buy the stock outright, buy its futures, or purchase a call option.
If you are pessimistic about a stock, you have three options: short futures, short call options, or sell the shares immediately (but only on an intraday basis).
Regardless of whether you are an option buyer or seller, the intrinsic value computation for call options is the same.
But for a “Put” option, the intrinsic value computation is different.
The call option buyer and seller use various methodologies for calculating net P&L.
To better understand the P&L behavior, we have examined the P&L over the course of the last four chapters while keeping the expiry in mind.
To determine if he will be lucrative or not, one need not wait for the option to expire.
The majority of options trading is driven by changes in premiums.
For instance, if I purchased a Bajaj Auto 2050 call option at Rs. 6.35 in the morning and it trades at Rs. 9 by noon, I can decide to sell and realize a profit.
The premiums fluctuate constantly due to a number of factors, all of which we shall comprehend as we move through this lesson.
A call option is referred to as “CE.” Because of this, the Bajaj Auto 2050 Call option is also known as Bajaj Auto 2050CE. European Call Option is referred to as CE.

4.6 – European versus American Options

When options were first introduced in India, there were two different types: European options and American options. The stock options were American in character while all index options (Nifty, Bank Nifty options) were of European origin. The key area of distinction between the two was the “Options exercise.”

European Options – If an option is of the European kind, the option buyer will be required to wait until the option expires before exercising his right. The settlement is determined by the spot market price on the day of expiration. For instance, if he purchased a Bajaj Auto 2050 Call option, Bajaj Auto must rise over the breakeven threshold on the expiration day in order for the buyer to profit. Even if the option is not exercised, the buyer will forfeit the entire premium sum that was paid to the option seller.

American Options – During the period before the option expires, the option buyer may exercise his right to purchase the option anytime he sees fit. The payment depends on the spot market at that precise moment rather than genuinely on expiration. He purchases a Bajaj Auto 2050, for example. Call option now, with 20 more days till expiration and Bajaj trading at 2030 in the spot market. Bajaj Auto crosses 2050 the following day. The seller is required to settle with the option buyer if the buyer of the Baja Auto 2050 American Call option exercises his right in this situation. The expiration date is not really important in this case.

If you’re familiar with options, you might be wondering: “How does it matter if the option is American or European if we can buy an option now and sell it later, perhaps 30 minutes after we purchase?”

Ajay-Venu is a good example to ponder about again. Ajay and Venu agreed to review their arrangement in six months (this is like a European Option). Imagine if Ajay had insisted that he may come at any moment during the duration of the agreement to assert his right, rather than settling the matter after six months (like an American Option). For instance, there can be a persistent rumor regarding the highway project (after they signed off the agreement). Ajay decides to execute his right as a result of the strong rumor, which causes the price of the land to skyrocket. Venu will obviously have to give Ajay the land (even though he is very clear that the land price has gone up because of strong rumors). Venu would additionally need a larger premium because he runs the additional danger of being “exercised” on a day other than the expiration day.

American solutions are always more expensive than European options because of this.

You might also be interesting to hear that the NSE chose to fully eliminate the American Option from the derivatives section roughly three years ago. As a result, all options in India are currently of a European character, allowing the buyer to exercise it depending on the spot price on the expiration date.

We’ll now go on to comprehend the “Put Options.”

CONCLUSION

When you are skeptical about a stock, you sell a call option.
The P&L behavior of the call option buyer and seller is diametrically opposed.
You get paid a premium when you sell a call option.
You need to put down a margin before you can sell a call option.
When you sell a call option, your potential gain is constrained to the amount of the premium you receive, while the potential loss is limitless.
P&L is equal to Premium minus Max [0, (Spot Price – Strike Price)]
Strike Price + Premium Received is the breakdown point.
All possibilities are of a European kind in India.

How to buy call option

October 4, 2022August 3, 2022 by Bala gumber

Options

• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega

3.1 – Buying call option

In the preceding chapters, we examined the call option’s fundamental construction and learned the general circumstances in which buying a call option makes sense. We will formally organize our ideas about the call option in this chapter and have a solid understanding of both the purchasing and selling of the call option. Here is a quick summary of everything we learned in the first chapter before continuing with this one:

When you anticipate that the underlying price will rise, it makes sense to purchase a call option.
The buyer of the call option loses money if the underlying price declines or remains unchanged.
The premium (agreement fees) that the buyer pays to the seller/writer of the call option is equal to the amount of money that the buyer of the call option would lose.

We shall keep the aforementioned three considerations in mind (which act as fundamental principles) and gain a deeper understanding of the call option.

3.2 – Building a case for a call option

The purchase of a call option is in a variety of market circumstances. Here is one that I just learned about as I was writing this chapter and thought would be a good fit for our conversations.

Bajaj Auto Limited’s stock is being . They are one of India’s largest two-wheeler manufacturers, as you may know. The stock has been severely undervalued in the market for a number of reasons and is currently trading at its 52-week low. I think there might be a chance to start a trade here. I have the following opinions about this trade:

There is no disputing that Bajaj Auto is a stock with strong fundamentals.
Because of how much the stock has fallen, I think the market may have overreacted to the business cycle instability of Bajaj Auto.
I anticipate that the stock price will finally cease declining and stop short.
But because I’m concerned that the stock will continue to decrease, I don’t want to purchase the stock for delivery (yet).
Extending the previous point, I am unable to purchase Bajaj Auto’s futures due to my concern for M2M losses.
At the same time, I don’t want to pass up a chance for a significant stock price reversal.

In conclusion, I have high hopes for the stock price of Bajaj Auto (which I believe will rise eventually), but I have some trepidation regarding the stock’s near-term prospects. The major source of uncertainty is the potential severity of my short-term losses in the event that the stock’s decline continues. However, based on my estimation, the likelihood of the loss is minimal, but it is still possible. So what do I need to do?

As you can see, I’m in a situation that Ajay was in at the same time (recall the Ajay – Venu example from chapter 1). This kind of situation sets up a classic example of an options transaction.

In light of my predicament, purchasing a call option on Bajaj Auto makes sense for the reasons I’ll discuss in a moment.

As shown, the stock is currently trading at Rs. 2026.9. (highlighted in blue). With a premium of Rs. 6.35, I’ll decide to purchase a call option with a strike price of 2050. (highlighted in the red box and red arrow). You might be wondering why, since there are so many other strike prices available (highlighted in green), I chose the 2050 strike price. We will ultimately cover the process of choosing a strike price in this module, but for now, let’s assume that 2050 is the appropriate strike price to trade.

3.3 – Intrinsic value of a call option (upon expiry)

What transpires with the call option now that the expiration is 15 days away? In general, there are three possibilities that could occur, which I assume you are already aware of:

The stock price rises above the strike price, say 2080, in scenario one.

Scenario 2: The stock price declines to 2030, which is below the strike price.

The stock price remains at 2050 in scenario three.

I’ll also presume that you are familiar with the P&L calculation at the precise value of the spot in the three scenarios above as they are fairly similar to the ones we looked at in chapter 1. (if not, I would suggest you read through Chapter 1 again).

The concept I’m presently interested in investigating is this:

You will concur that there are just three major categories in which the price movement of Bajaj Auto may be (following expiration), namely, the price either rises, falls, or remains unchanged.
What about all the other prices in between, though? For instance, in Scenario 1, the price is set at 2080, which is higher than the striking price of 2050. What about further strike prices like 2055, 2060, 2065, 2070, etc.? Can we draw any conclusions about the P&L from this?
In scenario 2, the price is anticipated to be around 2030, which is less than the 2050 strike. How about more strike prices like 2045, 2040, 2035, etc.? Having said that, anything here with respect to the P&L?

I would want to refer to these points as the “Conceivable values of the spot on expiry” in order to generalize the P&L knowledge of the call option. What would happen to the P&L at various possible spot prices (upon expiry)?

To start, I’d like to discuss the concept of the “intrinsic value of the option at expiry” (in part, not the complete concept).

The non-negative value that the option buyer would be to if he were to exercise the call option is known as the intrinsic value (IV) of the option upon expiration (particularly a call option for now). Simply put, determine how much cash you would receive at expiration if the call option you own were profitable (assuming you are the buyer of the call option). It is in mathematics as –

IV = Strike Price – Spot Price

Therefore, the 2050 Call option’s intrinsic value would be if Bajaj Auto is trading at 2068 on the day of expiration (in the spot market).

= 2068 – 2050

= 18

Likewise, the intrinsic value of the option would be – if Bajaj Auto is trading at 2025 on the expiry day.

= 2025 – 2050

= -25

But keep in mind that the IV of an option is always a positive figure, whether it is a call or a put.

= 0

Now, our goal is to keep the notion of the option’s intrinsic worth in perspective, determine how much money I will make at each potential Bajaj Auto expiration value, and use that information to draw some broad conclusions about the P&L of call option buyers.

3.4 – Generalizing the P&L for a call option buyer

Now that we’ve kept the idea of an option’s intrinsic value in the back of our minds, let’s work to create a table that will show us how much money I, as the buyer of Bajaj Auto’s 2050 call option, would earn under the various potential spot value changes of Bajaj Auto (in the spot market) on expiration. Keep in mind that Rs 6.35 was as the premium for this choice. The fact that I Rs.6.35 remains intact, regardless of how the spot value fluctuates. This is the expense I incurred to purchase the 2050 Call Option.

What then do you notice? The table above reveals two notable observations:

The most that might be, even if Bajaj Auto’s price drops (below the strike price of 2050), appears to be just Rs. 6.35/-

1. Generalization 1: When the spot price declines below the strike price, the buyer of a call option suffers a loss. However, the call option buyer’s loss is only as great as the premium he has .

2. When Bajaj Auto begins to rise over the 2050 strike price, the profit from this call option appears to grow rapidly.

Generalization 2: When the spot price rises above the strike price, the call option is lucrative. The profit increases as the difference between the strike price and the current price rises.

3. The buyer of the call option has a restricted risk and the potential to earn a limitless profit, according to the aforementioned two generalizations.

The Call option P&L for a specific spot price can be using the following generic formula:

Max [0, (Spot Price – Strike Price)] = P&L – Premium

Let’s examine the P&L for a few potential spot values on expiry using the formula above:

2023 \s2072 \s2055

The answer is as follows:

@2023

= Max [0, (2023 – 2050)] – 6.35

= Max [0, (-27)] – 6.35

= 0 – 6.35

= – 6.35

The resolution fits Generalization 1 (loss restricted to the extent of the premium ).

@2072

= Max [0, (2072 – 2050)] – 6.35

= Max [0, (+22)] – 6.35

= 22 – 6.35

= +15.65

The solution fits Generalization 2. (Call option gets profitable as and when the spot price moves over and above the strike price).

@2055

= Max [0, (2055 – 2050)] – 6.35

= Max [0, (+5)] – 6.35

= 5 – 6.35

= -1.35

This presents a challenging circumstance because the outcome goes against the second generalization. The trade is losing money even though the spot price is higher than the strike price! What causes this? Furthermore, the actual loss is substantially lower than the maximum loss of Rs. 6.35/-; it is just Rs. 1.35/-. We need carefully examine the P&L activity surrounding the spot value, which is marginally over the strike price, to ascertain why this is occurring (2050 in this case).

As you can see from the table above, until the spot price reaches the strike price, the buyer incurs a maximum loss (in this example, Rs. 6.35). The loss begins to diminish, though, once the spot price begins to rise above the strike price. Up until a moment where neither a profit nor a loss is from the trade, the losses are continuously. The breakeven point is what we refer to as.

Any call option’s breakeven point can be using the following formula:

B.E. = Strike Price Plus Premium

The “Break Even” point for the Bajaj Auto example is –

= 2050 + 6.35

= 2056.35

Let’s actually determine the P&L at the breakeven point.

= Max [0, (2056.35 – 2050)] – 6.35

= Max [0, (+6.35)] – 6.35

= +6.35 – 6.35

= 0

As you can see, at the breakeven point, we are in the negative financially. In other words, for the call option to become profitable, it must move above both the strike price and the breakeven point.

3.5 – Call option buyer’s payoff

We have already discussed a few crucial aspects of a call option buyer’s payment, so let me restate them here:

The greatest loss a call option buyer can incur is equal to the premium amount. As long as the spot price is lower than the strike price, the buyer loses money.
If the current price rises over the strike price, the buyer of the call option could benefit indefinitely.
Even though the call option is meant to provide income when the spot price rises above the strike price, the buyer must first recoup the premium he has already paid.
The breakeven point is the point at which the buyer of a call option fully recoups the premium he has paid.
Only after passing the breakeven mark does the call option buyer actually begin to benefit (which naturally is above the strike price)

The following points, which are consistent with our recent discussion, can be seen in the graphic above:

As long as the spot price is trading at any price below the strike of 2050, the loss is limited to Rs. 6.35.
Losses can be shown to decrease from 2050 to 2056.35 (breakeven price).
We can see that there is no profit or loss at 2056.35.
The call option starts to profit above 2056.35. In reality, the P&L line’s slope plainly shows that when the spot value moves away from the strike, the profits begin to rise exponentially.

One thing is clear from the graph once more: A call option buyer has low risk but unlimited profit potential. And with that, I hope you have a better understanding of the call option from the standpoint of the buyer. We shall examine the Call Option from the seller’s standpoint in the following chapter.

CONCLUSION

When you anticipate that the underlying price will rise, it makes sense to purchase a call option.
The buyer of the call option loses money if the underlying price declines or remains unchanged.
The premium (agreement fees) that the buyer pays to the seller/writer of the call option is equal to the amount of money that the buyer of the call option would lose.
A call option’s intrinsic value (IV) is a non-negative number.
IV = Max[0, strike price minus spot price]
The maximum loss a call option buyer can incur is equal to the premium they paid. As long as the spot price is lower than the strike price, a loss is incurred.
If the current price rises over the strike price, the buyer of the call option could benefit indefinitely.
Even though the call option is meant to provide income when the spot price rises above the strike price, the buyer must first recoup the premium he has already paid.
The breakeven point is the point at which the buyer of a call option fully recoups the premium he has paid.
Only after passing the breakeven mark does the call option buyer actually begin to benefit (which naturally is above the strike price).

Basics of options jargons

October 4, 2022August 2, 2022 by Bala gumber

Options

• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega

2.1– Decoding the basic jargons

We were familiar with the fundamental call option structure from the previous chapter. The goal of the previous chapter was to summarise a few crucial “Call Option” ideas, including:

When you anticipate that the underlying price will rise, it makes sense to purchase a call option.
The buyer of the call option loses money if the underlying price declines or remains unchanged.
The premium (agreement fees) that the buyer of the call option pays to the seller/writer of the call option is equal to the amount of money that the buyer would lose.

We will try to comprehend the call option in greater detail in the following chapter, called Call Option (Part 2). However, let’s first explain a few common option jargons before moving on. Talking about these terminologies now will not only improve our understanding, but it will also make the discussion of the possibilities that will follow simpler to understand.

We shall examine the following jargon:

Strike Cost
Fundamental Price
A contract for an option is
Choice Expires
Choice Premium
Optional Agreement

Please keep in mind that as we have only examined the call option’s fundamental structure, I would advise you to solely comprehend these terms in relation to call options.

Strike Cost

Think of the striking price as the anchor price at which the buyer and seller (of the option) concur to engage in a contract. For instance, the anchor price in the “Ajay – Venu” example from the previous chapter was Rs. 500,000, which also served as the “Strike Price” for their agreement. We also looked at a stock example where the strike price and anchor prices were both 75 rupees. The strike price for all “Call” options denotes the price at which the stock may be on the expiration day.

For instance, if the buyer is willing to pay a premium today to purchase the right to “buy ITC at Rs. 350 on expiration,” they are eager to buy ITC Limited’s call option with a strike price of Rs. 350. It goes without saying that he will only purchase ITC at a price above Rs. 350.

In reality, below is a screenshot of the NSE website where I have included various ITC strike prices and the corresponding premium.

An “Option Chain” is the table you see above, and it basically summarises all the various strike prices that are for a contract along with the premium for the same. In addition to this data, the option chain contains a wealth of additional trade data, including Open Interest, volume, bid-ask quantity, etc. I advise you to ignore everything else for the time being and focus just on the material that has been highlighted.

The underlying’s spot price is in the maroon highlight. As we can see, ITC was trading at Rs. 336.9 per share at the time of this picture.
All of the different strike prices that are are highlighted in blue. Strike rates range from Rs. 260 (with Rs. 10 intervals) up to Rs. 480, as can be.
Keep in mind that each striking price stands alone. By paying the necessary premium, one can enter into an options agreement at a particular strike price.
For instance, a 340 call option can be by paying a premium of Rs. 4.75. (highlighted in red)

This gives the buyer the option to purchase ITC shares for Rs. 340 at expiration. Of course, you now see the situation in which purchasing ITC at 340 on expiration day would be advantageous.

Fundamental Price

As is common knowledge, the value of a derivative contract is derived from the underlying asset. The price at which the underlying asset trades on the spot market is known as the underlying price. For instance, ITC was trading at Rs.336.90/- in the spot market when we examined that case. The underlying price is as follows. In order for the buyer of a call option to profit, the underlying price must rise.

A contract for an option is exercised

Claim your right to purchase the options contract at expiration by exercising your option contract. When someone says, “exercise the option contract,” they simply mean that they are asserting their right to purchase the stock at the specified strike price. It is obvious that he or she would only act in this manner if the stock is trading over the strike. A key detail to keep in mind is that you can only exercise the option on the day it expires, not at any other time.

Therefore, let’s imagine that someone purchases an ITC 340 Call option with 15 days remaining when ITC is trading at 330 in the spot market. Assume further that the stock price rises to 360 the following day after he purchases the 340 call option. In such a case, the call option holder cannot exercise his call option and cannot ask for a settlement. Only on the day of the expiry will settlement take place, and it will be on the price the asset is trading for on that day in the spot market.

Choice Expires

The same as a futures contract, an options contract has an expiration date. In reality, the last Thursday of every month is the expiration date for both equity futures and options contracts. Options contracts have the same current month, mid-month, and far-month ideas as futures contracts.

The call option to purchase Ashok Leyland Ltd. at a strike price of Rs. 70 is shown in this snapshot at a price of Rs. 3.10/-. As you can see, there are three expiration dates: March 26, 2015, April 30, 2015, and May 28, 2015. (far month). Of course, as and when the expiry changes, the option premium also does. We will discuss it further when the moment is right. But at this point, I just want you to keep in mind two things about expiry: just with futures, there are three possible expiry options, and the premium varies depending on which option you choose.

Choice Premium

Since we’ve already talked about the premium on a few occasions, I assume you now understand a few things regarding the “Options Premium.” The premium is the sum of money that the option buyer must pay to the option seller or writer. The option buyer purchases the right to exercise his wish to buy (or sell, in the case of put options) the asset at the strike price upon expiration in exchange for the payment of a premium.

We must be going in the correct direction if you have understood this portion up to this point. We’ll now go on to comprehend a fresh viewpoint on “premiums.” Additionally, I suppose it is crucial to point out at this point that the “Options Premium” is what the entire concept of option theory depends on. When trading options, option premiums are a very important factor. You’ll notice as we go through this lesson that the choice premium will eventually take up a lot of the talks.

Let’s go back to the “Ajay-Venu” scenario from the previous chapter. Think about the conditions in which Venu agreed to accept Ajay’s premium of Rs.

News coverage – There was only speculative coverage of the highway project, and it was unclear whether it would actually proceed.

1. Consider that in the last chapter, we examined 3 potential outcomes, of which 2 were in Venu’s favor. Venu, therefore, stands to gain more from the arrangement while not having an inherent statistical advantage, given that highway news is hypothetical.

2. Time – There were six months to determine if the initiative would be successful or not.

This argument works in Ajay’s favor. There is a greater chance that the event will favor Ajay because there is more time before it expires. Take this as an example: If you were to run 10 kilometers, would you be more likely to finish it in 20 minutes or 70 minutes? Of course, the likelihood of success increases with the length of time.

Now let’s take a look at both of these issues separately and determine how they might affect the options premium.

Due to the completely hypothetical nature of the news at the time of the contract between Ajay and Venu, the latter was happy to accept the premium of Rs. 100,000. Let’s just pretend for a second that the news was and not hypothetical. Perhaps a local legislator made a suggestion during the most recent news conference that a motorway might be for that location. The news is no longer a rumor after learning this information. Suddenly, though there is still some speculation, there is a chance that the motorway might actually appear.

Consider this in context: Do you believe Venu will accept Rs. 100,000 as a premium? He is aware that there is a good likelihood the motorway would be built, in which case land prices would rise. But given that there is still a chance component, he might be willing to take the risk if the premium is more alluring. The deal might be more appealing to him if the premium was Rs. 175,000 instead of Rs. 100,000.

Let’s now consider this in the context of the stock market. Assume that Infosys is currently trading at Rs. 2200. The cost of the 2300 Call option with a one-month expiration is Rs. 20. Consider yourself in Venu’s (the option writer’s) position: Would you sign a contract accepting Rs. 20 per share as premium?

You provide the buyer the right to purchase an Infosys option at Rs. 2300 one month from now if you enter into this options agreement as a writer or seller.

Assume that no foreseen corporate activity will cause the share price of Infosys to increase throughout the course of the ensuing month. Given this, you might agree to accept the Rs. 20 premium.

What happens, though, if a corporate event (such as quarterly reports) tends to boost the stock price? Will the option seller continue to accept Rs. 20 as the agreement’s premium? It is obvious that taking the risk of Rs. 20 may not be worthwhile.

Having stated that, what if someone is willing to pay Rs. 75 as premium rather than Rs. 20 notwithstanding the planned corporate event? At Rs. 75, I suppose it could be worthwhile to take a chance.

Let’s keep this conversation in the back of our minds as we move on to the second item, which is time.

Ajay knew for sure that six months would be enough time for the dust to settle and the whole story about the motorway project to come to light. What if there were just 10 days in the future, as opposed to 6 months? There is simply not enough time for the event to take place now that time has passed. Do you believe Ajay will be content to give Venu an Rs. 100,000 premium in this situation (where time is not on Ajay’s side)? I don’t think so because Ajay wouldn’t be motivated to provide Venu with such a high premium.

Perhaps he would settle for a lower premium, like Rs. 20,000.

Anyway, the point I want to convey here is that premium is never a set rate, keeping both news and time in context. It is susceptible to a number of things. In actual markets, all of these factors function simultaneously and have an impact on the premium. Some factors tend to raise the premium while others tend to lower it. In detail, there are 5 factors that tend to influence the premium (akin to news and time). They are referred to as “Option Greeks.” We won’t grasp the Greeks until much later in this module since it’s too early for us to understand them now.

I want you to keep in mind and be grateful for the following things in relation to the option for the time being premium –

The Option Theory depends on the idea of premium.
A premium is never a fixed rate; instead, it depends on a variety of other factors.
Premiums in actual marketplaces fluctuate practically minute by minute.

I can promise you that you are on the right track if you have acquired and comprehended these concepts thus far.

Settlement of Options

This is a call option to purchase JP Associates at Rs. 25 as indicated in the green accent. The deadline is March 26, 2015. The market lot is made up of 8000 shares, and the premium is Rs.1.35/- (highlighted in red).

Assume that “Trader A” and “Trader B” are the only two traders. Both Trader A and Trader B are interested in purchasing this contract (the option buyer).

Given that the contract is for 8000 shares, the cash flow would be as follows:

Trader A must pay the whole amount of Rs.1.35 per share, which is the premium.

= 8000 * 1.35

= A premium payment of Rs. 10,800 to Trader B.

Now, if Trader A decides to exercise his agreement, Trader B is bound to sell Trader A 8000 shares of JP Associates on March 26, 2015, as a result of Trader B receiving this Premium from Trader A. This does not, however, imply that Trader B should be carrying 8000 shares on March 26. Indian options are cash settled, therefore if trader A decides to exercise his right on March 26, trader B is only required to pay the cash difference to Trader A.

Take into account that JP Associates is trading at Rs. 32/- on March 26 in order to better grasp this. As a result, Trader A, the option buyer, will exercise his option to purchase 8000 shares of JP Associates at a price of 25/-. In other words, he receives the opportunity to purchase JP Associates at a discount from its open market price of Rs. 32.

Typically, the cash flow should look like this:

Trader A exercises his option to purchase 8000 shares from Trader B on the 26th.
The transaction will take place at a predetermined price of Rs. 25. (strike price)
Trader A gives Trader B (8000 * 25) rupees.
Trader B releases 8000 shares to Trader A for Rs. 25 in exchange for this payment.
Trader A quickly sells these shares on the open market for Rs. 32 each, earning Rs. 256,000.
In this trade, Trader A earns a profit of Rs. 56,000 (256,000 – 200000).

The option buyer is generating a profit of Rs. 7 per share (32-25) per share, to put it another way. Instead of sending the option buyer 8000 shares since the option is cash-settled, the option seller instead gives him the cash equivalent of the profit he would have made. Therefore, Trader A would get

= 7*8000

= 56,000 rupees from Trader B.

Considering that the option buyer had initially invested Rs. 10,800 in acquiring this privilege, his actual profits would be:

= 56,000 – 10,800

= Rs.45,200/-

This actually yields a staggering return of 419 percent when expressed in terms of percentage return (without annualizing).

Options are a desirable trading instrument due to the substantial asymmetric return that may be achieved. This is only one of the many factors that traders find options to be so appealing.

CONCLUSION

Only when one predicts an increase in the price of an asset does it make sense to purchase a call option
The anchor price at which both the option buyer and writer enter into a contract is known as the strike price.
The asset’s spot price serves as the underlying price.
Claim your right to purchase the options contract at expiration by exercising your option contract.
The expiry of an options contract is similar to that of a futures contract. Every month’s final Thursday is the expiration date for option contracts.
The current month, mid-month, and distant-month contracts of an option contract each have a separate expiration date.
Premiums are not fixed; rather, they change depending on a number of circumstances.
Options are settled in cash in India.

Basics of call options

August 2, 2022 by Bala gumber

Options

• Option contract
• The option greeks
• Delta
• Gamma
• Theta
• All volatility
• Vega

1.1– Breaking the Ice

We will once again operate on the presumption that you are unfamiliar with alternatives and as a result know nothing about them, just like we did with any of the previous Varsity modules. We shall therefore start from scratch and gradually build up as we go. Let’s begin by going over some fundamental background details.

Particularly in India, the derivative market is dominated by the options market. If I said that options made up roughly 80% of the derivatives traded and that the remaining 20% came from the futures market, I wouldn’t be exaggerating. The options market has been internationally for some time; for a fast overview, see the following:

Since the 1920s, custom options have been sold over the counter (OTC). These options mostly covered commodities.
The Chicago Board Options Exchange (CBOE) started trading options on stocks in 1972.
Bond and currency options were first offered in the late 1970s. Once more, they were OTC trades.
The Philadelphia Stock Exchange introduced exchange-traded options on currencies in 1982.
Trading in interest rate options on the CME first started in 1985.

Clearly, since the OTC era, the global markets have undergone significant change. The exchanges in India, however, have supported the options market since its start. However, the off-market “Badla” system offered possibilities. Consider the “badla system” as a shadow market for derivatives deals. The badla system is no longer in use; it is out of date. An overview of the development of the Indian derivative markets is provided below:

Launch of index futures on June 12th, 2000
Launch of index options on June 4th, 2001
On July 2, 2001, stock options became available.
Launch of single stock futures on November 9th, 2001.

Despite the options market’s existence since 2001, it wasn’t until 2006 that it experienced real liquidity for Indian index options. Back then, when I was trading options, the spreads were wide, and obtaining fills was a major thing. The value was however unlocked for the shareholders in 2006 when the Ambani brothers formally split up and their various businesses were listed as separate corporations.

1.2 – A Special Agreement

There are two different kinds of options: call and put. You have the option of buying or selling these options. Your actions affect how the P&L profile looks. Of course, we’ll talk about the P&L profile much later. Let’s first define what “The Call Option” means. The greatest method to comprehend a call option is really to start with concrete, real-world example. Once we comprehend this example, we can generalize the concept to stock markets. Therefore, let’s begin.

Think about this scenario: Ajay and Venu are two close buddies. Ajay is actively weighing the possibility of purchasing an acre of land from Venu. The worth of the land is Rs. 500,000. Ajay has been advised that a new roadway project is most likely to be approved next to the property owned by Venu within the next six months. Ajay would profit from the investment he would make today if the motorway is built because it is likely to improve the value of the land. Ajay would be stuck with a useless plot of property if the “highway news” turns out to be untrue, meaning he would purchase the land from Venu today and there would be no roadway tomorrow.

What then ought Ajay to do? Ajay is unsure whether or not to purchase the land from Venu, therefore it is clear that this event has put him in a difficult position. Ajay is confused about this, but Venu is adamant about selling the land to Ajay if he wants to buy it.

Ajay wants to be cautious, so he considers everything that is going on and ultimately suggests to Venu a unique, organized arrangement that he believes will benefit both of them. The specifics of the agreement are as follows:

Ajay makes a one-time payment of Rs. 100,000 today. Consider this to be Ajay’s non-refundable agreement fee.
In exchange for these monies, Venu consents to sell the land to Ajay after six months.
The sale price, which is anticipated to take place in six months, has been set at Rs. 500,000.
Only Ajay can cancel the agreement after six months because he paid an upfront fee; Venu is unable to do so.
If Ajay cancels the agreement after six months, Venu keeps the upfront costs.

What do you think of this unique deal, then? Who do you believe is smarter in this situation, Ajay for suggesting such a complex arrangement or Venu for accepting it? Well, until you thoroughly investigate the agreement’s terms, the answers to these questions are not simple. You should carefully read through the example because Ajay has crafted a very sophisticated arrangement there. It also serves as the foundation for understanding alternatives. In actuality, this agreement contains a variety of sides.

To grasp the specifics of Ajay’s plan, let’s split it down:

Ajay enters into a deal with Venu by paying a fee of Rs. 100,000. For the next six months, he is compelling Venu to lock the land on his behalf.
Ajay is determining the sale price of the land based on the current price, which is Rs. 500,000. This means that regardless of the price six months from now, he would be able to purchase the land at the current price. Please take note that he is setting a price and paying an extra Rs. 100,000 today.
Ajay has the right to tell Venu “no” at the conclusion of the six months if he decides not to purchase the land, but since Venu has already collected the agreement fee from Ajay, he is unable to do so.
The agreement fee is not refundable and cannot be negotiated.

After starting this deal, Ajay and Venu must now wait the ensuing six months to find out what will truly occur. It is obvious that the cost of the land will change depending on how the “highway project” turns out. However, there are only three scenarios that could occur regardless of what happens to the highway:

The cost of the land would increase once the highway building was underway, perhaps soaring to Rs. 10,000,000.
People are disappointed when the highway project is abandoned and the price of land drops to, say, Rs. 300,000.
Nothing changes; the price remains at Rs. 500,000.

Additional to the three eventualities described above, I’m positive there are no other outcomes that might happen.

We will now put ourselves in Ajay’s position and consider what he would do in each of the aforementioned circumstances.

Scenario 1: The price increases to Rs.10,000.

The price of land has increased since the motorway project materialized as Ajay had anticipated. Keep in mind that, according to the contract, Ajay has the right to terminate the relationship after six months. Do you think Ajay would cancel the transaction now that the land price has increased? Not exactly, as Ajay stands to gain from the sale’s dynamics.

The land is currently being sold for Rs.10,000,000.

Value of the Sale Agreement: Rs. 500,000

As a result, Ajay now has the option to purchase a plot of land for Rs. 500,000 even though it would normally sell for Rs. 10,000 in the free market. Ajay is definitely getting a great deal here. He would therefore demand that Venu sell the land to him. For no other reason than the fact that he had previously collected Rs. 100,000 from Ajay as agreement fees, Venu is compelled to sell him the land at a lower price.

How much money does Ajay now make? Here is the math, though:

Purchase Price: Rs. 500,000

Additional Fees = Rs. 100,000 (remember this is a non refundable amount)

Total Cost = (500,000 + 100,000)/-

The land’s current market value is Rs. 10,000,000.

His profit is therefore Rs. 10,000, 000 – Rs. 600, 000, or Rs. 400,000.

Another way to look at this is that Ajay is now earning four times as much money for an initial monetary commitment of Rs. 100,000! Even though Venu is well aware that the land would fetch a far greater price on the open market, he feels compelled to give Ajay a considerably lesser price. Ajay’s profit of Rs. 400,000 corresponds exactly to the hypothetical loss that Venu would suffer.

Situation 2: Price drops to Rs. 300,000

It turns out that the highway project was only a rumor, and nothing significant is truly anticipated to come of it. People are dissatisfied, thus there is an unexpected rush to sell the land. The cost of the land decreases to Rs. 300,000/- as a result.

What do you suppose Ajay will do going forward? He would back out of the contract because it is obvious that buying the land is not a good idea. Here is the math that demonstrates why purchasing the land is ineffective:

Keep in mind that the sale price was set at Rs. 500,000 six months ago. Therefore, Ajay would need to pay Rs. 500,000 to purchase the land in addition to the Rs. 100,000 he had already paid for the agreement costs. Thus, he is effectively spending Rs. 600,000 to purchase a plot of land that is only worth Rs. 300,000 in total. Ajay would obviously not understand this since he has the authority to cancel the contract and would just refuse to purchase the land.

Keep in mind, too, that Ajay is required to forfeit Rs. 100,000 per the agreement, giving Venu the money instead.

Situation 3: The price remains at Rs. 500,000.

For whatever reason, the price does not significantly alter after six months and remains at Rs. 500,000. What do you anticipate Ajay doing? He won’t buy the land, of course, and will walk away from the agreement. If you’re wondering why the math is as follows:

The land cost is Rs. 500,000.

Fee for Agreement: Rs. 100,000

Total: 600,000 rupees

The open market value of the land is Rs. 500,000.

It is obvious that purchasing a plot of land for Rs. 600,000 when its value is Rs. 500,000 is absurd. Remember that Ajay can still purchase the land even if he has already committed Rs 1lakh, but he will incur an additional cost of Rs 1lakh. Due to this, Ajay will terminate the contract and forfeit the agreement price of Rs. 100,000. (which Venu obviously pockets).

I hope you comprehended this transaction completely, and if you did, that’s great since it means you already understand how call options operate thanks to the example! But let’s wait before applying this to the stock markets; we’ll continue to focus on the Ajay-Venu transaction.

Here are some questions and answers concerning the transaction that may help to clarify the example:

Why do you suppose Ajay placed such a wager even though he is aware that he will lose his one lakh rupees if land prices do not rise or remain the same?

1. Agreed The best aspect is that Ajay already knows his maximum loss (which is one lakh) before the event. Therefore, he won’t experience any unpleasant surprises. Additionally, his profits would increase as and when the price of the land did (and therefore his returns). At Rs.10,000, he would have a 400 percent profit on his investment of Rs.100,000, or Rs.400,000.

2. What conditions would make sense for a position like Ajay’s?

only in the event that the cost of the land rises

3. What conditions might Venu’s position make sense in?

only in the event that land prices drop or remain unchanged

4. Do you know why Venu is taking such a large chance? If land prices rose after six months, he would suffer a significant financial loss, correct?

Well, consider it. There are only 3 conceivable outcomes, and only 2 of them are favorable to Venu. According to statistics, Venu has a 66.6% chance of winning the wager compared to Ajay’s 33.3% likelihood.

Now, let’s review a few crucial issues.

The payment made by Ajay to Venu ensures that Ajay has a right (keep in mind that only he has the authority to cancel the agreement) and Venu has a duty (if the circumstances call for it, he must uphold Ajay’s claim).
The cost of the land will decide how the agreement turns out when it expires (at the end of six months). Without the land, the contract is worthless.
Thus, the arrangement is referred to as a derivative, and land is referred to as an underlying.
Such a contract is known as an “Options Agreement.”
Venu is referred to as the “agreement seller or Writer” and Ajay is referred to as the “agreement buyer” because Venu received the advance from Ajay.
In other words, Ajay can be referred to as an Options Buyer and Venu as the Options Seller/writer as this arrangement is referred to as “an options agreement”.
The price of this option agreement is 1 lakh because it was entered into after exchanging 1 lakh. Additionally known as the “Premium” amount
Each and every variable in the agreement, including the price and the sale date, is fixed.
As a general rule, the buyer always has a right and the seller always has a responsibility in an options agreement.

You should use this example very carefully, in my opinion. If not, read it once more to fully get the dynamics. Please keep in mind this example as well, as we will refer to it several times in the chapters that follow.

Let’s now examine the identical case from the viewpoint of the stock market.

1.3 – The Call Option

In order to better comprehend the “Call Option,” let’s try extrapolating the same scenario to the stock market. Please take note that I will purposely omit the specifics of options trading at this point. The goal is to comprehend the call option contract’s basic elements.

Let’s say a stock is currently trading at Rs. 67. If you were given the option to purchase the identical security one month from today for, let’s say, Rs. 75/-, would you do so only if the share price was higher on that day than Rs. 75? Of course, you would, since this means that even if the share is trading at 85 after a month, you can still get to buy it at Rs. 75!

You need to pay a tiny fee today, let’s say Rs. 5.0/-, to get this right. You have the option to exercise your right and purchase shares at Rs. 75 if the share price rises above that level. If the share price remains at or below Rs. 75, you are not required to exercise your entitlement to purchase shares and do not need to do so. You only stand to lose Rs. 5 in this scenario. This type of agreement is known as an option contract, specifically a “call option.”

There are only three possible outcomes after you enter into this arrangement. They are, too.

The stock price may increase, say by Rs. 85.
The stock price may decrease, say by Rs. 65.
The share price may remain at Rs.75/-

Case 1: It would make sense to exercise your right and purchase the stock at Rs. 75 if the stock price increases.

The P&L would seem as follows:

The purchase price of the shares is Rs. 75.

Paid premium equals Rs.

The cost incurred equals Rs. 80.

Price in the Open Market: Rs. 85

Profit: 85 minus 80, or Rs. 5

Case 2: If the stock price drops to, say, Rs. 65, buying it for Rs. 75 makes no sense because you would be effectively paying Rs. 80 (75 + 5) for a stock that is accessible at Rs. 65 on the open market.

Case 3: Similarly, if the stock price remains unchanged at Rs. 75, it simply means that you are spending Rs. 80 to purchase a stock that is on the market for Rs. 75. As a result, you would not exercise your option to purchase the stock at Rs. 75.

It’s so easy, right? If you comprehend this, you really comprehend the fundamental reasoning behind a call option. The finer details, all of which we will shortly understand, remain unexplained.

What you need to realize at this point is that purchasing a call option always makes sense whenever you anticipate that the price of a stock (or any other asset) will grow for the reasons we have already covered.

Here is a formal definition of a call options contract before I conclude this chapter.

“The buyer of the call option has the right, but not the responsibility, to purchase from the option seller at a specific time (the expiration date) for a specific price an agreed-upon quantity of a specific commodity or financial instrument (the underlying)” (the strike price). If the buyer chooses to purchase the commodity or financial instrument, the seller (or “writer”) is compelled to do so. For this right, the purchaser pays a charge (known as a premium).

The “Call Option” will be examined in more detail in the following chapter.

CONCLUSION

Options have been traded in Indian exchanges for more than 15 years, although actual liquidity only became available in 2006.
A tool for defending your position and lowering risk is an option.
The seller is required to deliver to the call option buyer, and the buyer has the right to do so.
Only one side to the transaction is given the option (the buyer of an option)
The option writer is another name for the option seller.
The “Premium” amount is what the option buyer pays the option seller at the time of the agreement.
The agreement takes place at a predetermined cost, frequently referred to as the “Strike Price.”
Only when the asset’s price rises over the strike price do the option buyer profit.
It always makes sense to buy options when you anticipate a price gain since if the asset price remains at or below the strike, the buyer is not rewarded.
In a typical option deal, the option seller has a better statistical chance of succeeding.
The option will become worthless if the directional perspective does not materialize before the expiration date.

DCF Primer

September 29, 2022August 2, 2022 by Bala gumber

Fundamental Analysis

• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow

• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes

14.1 – The Stock Price

Firslty, We discussed stage 1 and stage 2 of equity research in the previous chapter. Understanding the business was the focus of stage 1, and comprehending the company’s financial performance was the focus of stage 2. Only those who are convinced by the conclusions of the first two rounds may move on to step 3. The valuation of stock prices is covered in Stage 3.

Only when a great business is acquired at a great price is an investment deemed to be a great investment. In fact, if you can get a terrific deal on it, I’d go so far as to suggest that buying a subpar company is fantastic. This just serves to highlight the importance of “the price” in terms of investing.

The purpose of the following two chapters is to clarify “the price” for you. The price of a stock can be estimated using a valuation method. You can determine the company’s “intrinsic value” with valuation per se. Undoubtedly, The “Discounted Cash Flow (DCF) approach” is a valuation method that we employ to determine the company’s intrinsic value. The intrinsic value as determined by the DCF approach involves assessing a company’s “perceived stock price” while taking into account all potential future cash flows.

The DCF model is composed of a number of principles that are interconnected. Naturally, we must first comprehend each of these ideas on its own before applying them to DCF. We will first learn about the fundamental DCF concept known as “The Net Present Value (NPV)” in this chapter, after which we will learn about the other DCF ideas before learning about DCF as a whole.

14.2 – The future cash flow

The DCF model’s central idea is future cash flow. A straightforward example will allow us to comprehend this.

Let’s say Vishal sells the best pizzas in the area. His love of making pizzas inspires him to innovate. He creates a pizza oven that bakes pizzas automatically. He only needs to place the components for a pizza in the slots supplied, and within five minutes, a fresh pizza will emerge. He calculates that he can generate Rs. 500,000 in annual earnings and that the machine will last 10 years with this one.

George, a buddy of his, is a big fan of Vishal’s pizza maker. George offers to buy it because it is so bad.

Besides, What do you believe should be George’s minimum price to Vishal in order to purchase this machine? We must first determine how economically beneficial this machine will be for George in order to respond to this question. If he purchases this equipment today (2014), it will bring in Rs. 500,000 for him every year for the following ten years.

Especially, I was hoping you could take notice that I’ve assumed the machine will begin producing money in 2015 out of convenience.

It is obvious that George will make Rs. 50,000,00 during the course of the following ten years, after which the machine will be useless. At this point, one thing is certain: whatever the price of this gadget is, it cannot be higher than Rs. 50,000,000.

Consider whether it makes sense to pay a price that exceeds the economic advantage that an entity provides.

Let’s imagine Vishal asking George to pay “Rs. X” to the machine in order to move forward with our calculation. At this point, let’s say that George has two choices: either invest the same amount of money in a fixed deposit program that ensures his capital and gives him an interest rate of 8.5 percent or pay Rs. X and buy the machine. Assume George chooses to purchase the machine over the fixed deposit option. This suggests that George has lost out on the chance to earn risk-free interest of 8.5 percent. This represents the “opportunity cost” of choosing to purchase the device.

We have determined three significant pieces of information thus far in our attempt to determine the pricing of the robotic pizza maker:

First of all, Over the following ten years, the pizza company will generate Rs. 50,000,00 in total cash flow.
secondly, Since the whole cash flow is known, it also follows that the cost of the machine should be lower than the cash flow it generates overall.
Thirdly, The investment option of earning 8.5 percent interest is the opportunity cost of purchasing the pizza machine.

Let’s continue while keeping the aforementioned three things in mind. Now let’s concentrate on cash flows. We are aware that George will profit from the machine for the following ten years, earning Rs. 500,000 years. Consider this: George is looking toward the future in 2014.

What is the current value of the Rs. 500,000 that he will receive in 2016?
What is the current value of the Rs. 500,000 that he would receive in 2018?
What is the current value of the Rs. 500,000 that he will receive in 2020?
How much, on average, is the present value of the future cash flow?

Surely, These questions can be answered by considering the “Time value of money.” In other words, I would be in a better position to price that machine if I could determine the value of all the projected cash flows from it in terms of today’s value.

Apart From this, Please be aware that in the section after this one, we will depart from the pizza issue.

14.3 – Time Value of Money (TMV)

Definitely, The time value of money is incredibly important in the world of finance. Almost all financial concepts use the TMV in some way. The time value of money is relevant in all areas, including discounted cash flow analysis, financial derivatives pricing, project financing, calculating annuities, etc. Consider the “Time value of money” as the engine, and the “Financial World” as the car itself.

Importantly, The idea of the time value of money is based on the idea that the value of money changes with time. In other words, a hundred rupees now may not be worth one hundred rupees in two years. In contrast, a hundred rupees in two years won’t be worth a hundred rupees now. There is always a window of opportunity as time passes. For that chance, money must be accounted for (adjusted).

Moving the “money today” through the future is necessary if we need to determine what the worth of our current currency would be in the future. The “Future Value (FV)” of the money is what is meant by this. The future money must be converted back to today’s terms if we must determine the value of money that we anticipate receiving in the future in terms of today. The “Present Value (PV)” of money is what is meant by this.

Eventually, Both times, the money must be adjusted for opportunity cost due to the passage of time. Compounding is the term used to describe this adjustment when determining the future worth of a financial asset. When we need to determine the present value of money, the process is known as “discounting.”

For that reason, I will give you the formula needed to compute the FV and PV without going into the really easy maths involved.

Example 1: Assuming an opportunity cost of 8.5 percent, what is Rs. 5000/- worth in 2014 dollars five years from now?

We are attempting to determine the future value of the money we currently possess, which is a case of future value (FV) computation.

**Future Value = Amount * (Opportunity Cost Rate + 1) Age in years.**

= 5000 * (1% plus 8.5%) 5

= 7518.3

This suggests that assuming an opportunity cost of 8.5 percent, Rs. 5000 today is equivalent to Rs. 7518.3 after 5 years.

Example 2: Assuming an opportunity cost of 8.5 percent, how much is Rs. 10,000/- in receivables worth today?

As we attempt to calculate the present value of future cash receipts in terms of today’s value, this is unmistakably a case of present value (PV) computation.

Amount / (1+Discount Rate) Equals Present Value Ages in years

10,000 divided by 1 plus 8.5% ^ 6

= 6129.5

Assuming a discount rate of 8.5 percent, this indicates that Rs. 10,000/- payable after 6 years is equivalent to Rs. 6,129.5 today.

Example 3: If I rephrase the first example’s question, how much is Rs. 7518.3 in receivables worth today at an opportunity cost of 8.5 percent?

We are aware that doing so necessitates computing the present value. Additionally, since we performed the opposite of this in Example 1, we are aware that the correct response is Rs. 5000. To verify this, let’s calculate the present value:

= 7518.3 / (1 plus 8.5%) 5

= 5000.0

Lastly, I suppose we are now prepared to return to the pizza problem, assuming you understand the idea of the time worth money.

14.4 – The Net Present Value of cash flows

We are still determining how much the pizza maker will cost. We are aware that in the future, George is qualified to receive a stream of cash flows as a result of owning the pizza machine.

How much is the future cash flow worth in terms of today’s money? is a query we previously posed. Please allow me to repeat it.

As can be seen, the cash flow is evenly distributed over time. Each future cash flow that is due must be discounted with the opportunity cost in order to be calculated.

Clearly, The term “Net Present Value (NPV)” refers to the total present value of all future cash flows. In this instance, the NPV is Rs. 32,80,842. This also indicates that the total present value of all future cash flows from the pizza machine is Rs. 32,80,842. This is roughly how much the pizza machine should cost George if he had to purchase it from Vishal. George must make sure the price is Rs. 32,80,842 or less, but definitely not more.

Consider this: What if a business took the place of the pizza machine? Can we discount every future cash flow the company generates to determine the value of its stock? Yes, we can accomplish this, and under the “Discounted Cash Flow” model, we actually will.

CONCLUSION

Firstly, We can estimate a stock’s price using a valuation model, such as the DCF model.
Next, The DCF model is composed of a number of interconnected financial ideas.
As you know, One of the most important financial concepts is the “Time Value of Money,” which is used in the DCF technique among other economic theories.
In Fact, The worth of money cannot be treated uniformly through time, therefore its value in today’s terms won’t necessarily be the same at some point in the future.
However, We must “time travel the money” after taking opportunity cost into account in order to compare money over time.
Generally, The estimated value of the money we have today at some point in the future is known as the “future value of money.”
The present value of money calculates the amount of money due in the future based on its current value.
Lastly, The total of all the present values of the future cash flows is what is known as the Present Net Value (NPV) of money.

Equity research

October 4, 2022August 1, 2022 by Bala gumber

Fundamental Analysis

• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow

• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes

What to expect?

In this chapter, we will build a methodology for carrying out a “limited resource” equity research after establishing the context in the previous chapter. I use the term “limited resource” because there aren’t many resources available to you and me as retail investors to do equities research. These sources include the internet, MS Excel, and the annual report of the company. While an Institution has access to financial databases like Bloomberg, Reuters, Factset, and others, access to corporate management, human resources (analysts), industry publications, etc. So, using the limited tools at my disposal, I want to show how one might better understand a company and its business. Of course, we’ll approach this exercise with the ultimate goal in mind, which is deciding whether to buy or not to buy a stock.

As stated in the previous chapter, the method of doing equity research will be divided into three stages:

Knowledge of the Business
the use of the checklist
Calculating intrinsic value (valuation) to determine the stock’s fair market value

Each of the aforementioned stages is divided into multiple steps. There is no fast way to do this, and none of these procedures should be compromised.

Stock Price vs Business Fundamentals

The first thing we do while researching a firm is to learn as much as we can about the industry. People frequently skip over this important stage and jump right into the stock price analysis. Well, if you have a short-term perspective, simply examining the stock price is fantastic. Understanding the business, though, is crucial for long-term investments.

You might be wondering why it’s significant. The answer is straightforward: the more you understand the business, the more likely you are to stick with your investment—especially in difficult times— (aka bear markets). Always keep in mind that during bad markets, prices react rather than business fundamentals. Knowing the firm and its operations inside and out provides you the conviction you need to continue holding the stock even if the market thinks otherwise. Bad markets are said to produce value, therefore if you have a strong belief in the company, you should think about investing in the stock during bear markets rather than actually selling it. This goes without saying, and it takes years of investing experience to grasp the reality that it is highly counter-intuitive.

Anyway, moving on, the company’s website and annual report are the greatest places to find information about the business. To understand how it is changing during business cycles, we need to at least review the most recent five years of annual reports.

Understanding the Business

Making a list of the questions we need to get answers to is a necessary first step in understanding the company. Please take note that you can read the company’s annual report and website to find the answers to all of these inquiries.

Here are a number of queries that, in my opinion, will aid us in our effort to comprehend the business.

These inquiries serve as discussion starters for comprehending any business. As you search for solutions, you’ll unavoidably start asking new questions that require solutions. If you use this Q&A format, it doesn’t matter which company you are considering. I have no doubt that you would significantly improve your understanding of the business. This is because participating in the Q&A process forces you to read and research the firm so extensively that you will begin to gain a deeper grasp of it.

Keep in mind that this is the first stage of the equity research procedure. Regardless of how appealing the organization appears, I would encourage you to stop further research if you notice red flags (or something amiss) while looking for the answers. Stage 2 of equity research is pointless in cases where there is a red signal.

I can tell you from experience that the first step of equity research, known as “Understanding the Company,” takes roughly 15 hours. After going through this process, I often try to write down my ideas in a way that captures all the crucial information I have learned about the organization. This fact sheet needs to be succinct and direct. If I can’t do this, it is obvious that I don’t know enough about the business. I move on to stage 2 of equity research, or “Application of Checklist,” after completing stage 1. Please keep in mind that the stages of equity research are sequential and ought to be completed in that sequence.

The second step of our equity investigation will now be conducted. Stage 2 can best be understood by putting the checklist into practice in a business.

Throughout this module, we have collaborated with Amara Raja Batteries Limited (ARBL). So I suppose it makes sense to review the checklist for the same company. Do not forget that while the firm may change, the foundation for equity research does not.

A word of warning before we continue: when we learn more about this company, the conversation will focus primarily on ARBL moving ahead. The purpose of this is not to demonstrate how effective or ineffective ARBL is, but rather to provide a framework for what I consider to be a “pretty adequate” equity research procedure.

Application of checklist

The first stage of the equity research procedure enables us to comprehend the how what, who, and why. We are better able to see the business as a whole thanks to it. No matter how appealing a business may appear to be, its financial results should also be appealing since, as they say, the proof of the pudding is in the eating.

The goal of the second stage of equity research is to aid in our understanding of the data and enable us to assess if the nature of the company and its financial performance are complementary. It is obvious that the company will not meet the criteria for an investible grade if they do not complement one another.

Let’s assess each item on the Amara Raja Batteries checklist and see what the statistics indicate. We’ll start by looking at the P&L elements for the company: Gross Profit, Net Profit, and EPS.

Earnings & Pat Growth

The rate of a company’s growth is the first indication that it might meet the criteria for the investable grade. We must look at the sales and PAT growth to assess the company’s expansion. We shall assess growth from two angles:

Growth year over year will show us how much the business improves each year. Keep in mind that there are cyclical changes in industries. From that angle, it is acceptable if a company experiences flat growth. Simply make sure you assess the competition and confirm that industry-wide growth is stable.
Compounded Annual Growth Rate (CAGR): The CAGR reveals how the business is developing and expanding over time and throughout business cycles. A strong, investable-grade business is typically the first to weather changes in business cycles. A healthy CAGR will eventually show this.

I favor making investments in businesses with a CAGR of over 15% that are growing (revenue and PAT).

18.6 percent is the 5-year CAGR revenue growth, while 17.01 percent is the 5-year CAGR PAT growth. These data points are intriguing and fit the definition of a healthy data set. We must still assess the other figures on the checklist, though.

The income per Share (EPS)

The profitability per share is shown by the earnings per share. The fact that the company’s EPS and PAT are increasing at comparable rates suggests that it does not dilute earnings by issuing new shares, which is positive for the existing shareholders. This can be viewed as a testament to the management’s abilities at the organization.

For FY14, the five-year EPS CAGR is 1.90 percent.

The margin of gross profits

Gross profit margins are determined using the following formula:

Profits/Net Sales in Gross

Where,

Net sales less the cost of goods sold equals gross profits.

As we learned about the inventory turnover ratio, the cost of goods sold is the price associated with producing the finished product. Let’s check how the gross profit margins of ARBL have changed over time.

The Gross Profit Margins (GPM) appear to be really impressive. The checklist demands a minimum GPM of 20 percent. ARBL has a lot more GPM than is necessary. This suggests a few things:

ARBL has a privileged position within the market hierarchy. This can be due to a lack of competition in the market, which allows a select few businesses to have higher margins.
Excellent operational effectiveness, which in turn reflects the management’s ability

Debt level – examine the balance sheet

The company’s profit and loss statement was mostly addressed in the first three items on the checklist. We’ll examine a couple of balance sheet items right now. The debt is among the most crucial lines on the balance sheet that we should pay close attention to. A significant degree of financial leverage is indicated by a rising level of debt. The growth that comes at the expense of financial leverage is highly risky. Also, keep in mind that a high debt level on the balance sheet indicates a high financial expense. This reduces the company’s retained earnings.

The debt status for ARBL is as follows:

Debt(INR Crs) Assessment –

Around 85Cr, the debt appears to have reached stability. In reality, the fact that the debt has decreased from FY 09–10 is good. I like to verify the debt as a percentage of “Earnings before Interest and Taxes” in addition to the interest coverage ratio (which we have already discussed) (EBIT). This only provides a brief overview of the company’s financial management. The ratio of debt to EBIT has decreased steadily, as is evident.

In my opinion, ARBL has managed its debt level effectively, which is a good thing.

Inventory Review

It only makes sense to check the inventory data if the business under evaluation is a manufacturer. Examining the inventory data benefits us in a number of ways:

A growing corporation will have rising PAT indicators and rising inventory levels.
A consistent number of inventory days reflects management’s operational effectiveness to some extent.

The number of days for inventory is more or less constant. In actuality, there are some indications of a minor deterioration. Please take note that we covered the calculation of the inventory number of days in the chapter before. Another encouraging aspect is that both the inventory and PAT are exhibiting a similar growth trend.

Sales against Receivables

We now examine the company’s receivables along with the sales figure. A sale supported by receivables is not a promising development. Many questions stem from the fact that it denotes credit sales. For instance, do the sales representatives of the corporation sell goods on credit? Is the business attempting to boost sales by giving suppliers tempting (but unsustainable) credit?

Here, the business has demonstrated steadiness. We might infer from the table above that a significant portion of their sales is not actually supported by receivables, which is very good. In fact, the receivables as a percentage of net sales have also exhibited symptoms of a drop, which is rather impressive, just like the inventory number of days.

Proceeds from Operations

In truth, this is among the most significant inquiries to make before choosing to invest in a business. The business should produce cash flows from operations; here is actually where the truth is revealed. There is some kind of warning sign when a business drains its operating cash flow.

Despite being somewhat unpredictable, the cash flow from operations has been positive for the past five years. This only indicates that ARBL’s primary business operations are profitable and can be deemed successful.

Income from Equity

In chapter 9 of this lesson, we spoke at length about return on equity. If you want to review it, I’ll encourage you to do so. Return on Equity (ROE) evaluates the return produced by the business in percentage while keeping the equity of the shareholders in mind. In a way, ROE gauges how profitable the company’s promoters are after investing their own money in it.

These figures are astounding. Personally, I prefer to invest in businesses with ROEs of over 20%. Keep in mind that the debt for ARBL is rather minimal. Since there is no undue financial leverage backing the good set of return on equity metrics, this is again very desired.

Conclusion

Remember that the equity research is still at stage 2. I believe ARBL will qualify for stage 2 on practically all of the necessary criteria. As an equities research analyst, you must consider stage 2’s output in light of your stage 1 findings (which deal with understanding the business). After going through these two steps, if you can form a comfortable judgment (based on facts), the company looks to have qualities that make it an attractive investment.

However, you must make sure the pricing is reasonable before purchasing the stock. We conduct exactly this in step 3 of the equity research process.

Getting started with the DCF Analysis

The preceding chapter covered “The Net Present Value (NPV)”. The DCF valuation model heavily relies on NPV. After grasping this idea, we must now comprehend a couple of additional subjects connected to the DCF valuation model. In fact, by using the DCF model for Amara Raja Batteries Limited, we shall learn more about these ideas (ARBL). This brings the third stage of equity research—the valuation—to a close.

Then looked at the future cash flows from the pizza machine in the previous chapter to determine the price, and we discounted those future cash flows back to determine the present value. To calculate the NPV, we totaled together all of the future cash flows’ current values. We also considered the possibility of the pizza machine being replaced by the company’s shares toward the end of the previous chapter. In that instance, all we’ll need to price the company’s shares with is an estimate of its expected future cash flows.

But what kind of financial flow are we referring to? And how do we predict a company’s future cash flow?

The Free Cash Flow (FCF)

The “Free Cash flow (FCF)” of the organization is the cash flow that we must take into account for the DCF Analysis. Free cash flow is essentially the surplus operational cash that the business earns after deducting capital expenses like the cost of land, buildings, and equipment purchases. After capital expenditures are taken into account, this is the money that shareholders receive. How much free cash a corporation can produce ultimately determines how healthy it is.

Free cash is the sum of money that remains after all expenses, including investments, have been met by the company.

The presence of free cash flows is a sign of a healthy business. As a result, investors frequently search for companies with discounted stock prices but strong or rising free cash flow because they assume that over time, the discrepancy will vanish and the share price will soon rise.

Therefore, free cash flow is useful in determining whether or not a company has made profits over a given year. In order to determine the company’s true financial health as an investor, consider the free cash flow in addition to the earnings.

Any company’s FCF can be easily computed by consulting the cash flow statement. The equation is –

FCF is the sum of cash from operating activities and capital outlays.

Please take note that after accounting for income tax, net cash from operating operations is calculated. The capital expenditure is shown in red, whereas the net cash from operating activities is highlighted in green.

You may now be asking yourself a reasonable question: Why calculate historical free cash flow when the goal is to determine future free cash flow? The simple explanation is that, as we work on the DCF model, we must project future free cash flow. The best method for predicting future free cash flow is to estimate historical average free cash flow and then increase free cash flow at regular intervals by a specific rate. The industry employs this routinely.

The next crucial question is how much our free cash flow will increase. So, you should anticipate a growth rate that is as conservative as feasible. Personally, I prefer to project the FCF out for at least ten years. To achieve this, I factor in a higher rate of growth for the first five years and a lower rate for the following five years. If you’re having trouble following along with this, I’ll advise you to do the following step-by-step computation.

Determine the typical free cash flow in step 1.

I start by estimating ARBL’s average cash flow for the last three years.

= 209.7 + 262.99 + (51.6) / 3

=Rs.140.36

To guarantee that we are averaging out excessive cash flows and taking into account the cyclical nature of the business, we took the average cash flow for the previous three years. For instance, ARBL’s most recent year’s cash flow was negative by Rs. 51.6 Cr. It is obvious that this does not accurately reflect ARBL’s cash flow, hence it is usually recommended to use average free cash flow estimates.

Determine the growth rate in step two.

Choose a price that seems affordable to you. The average cash flow will increase at this rate moving ahead. Typically, I develop the FCF in two stages. The first stage addresses the first five years, and the second stage addresses the subsequent last 5 years.

With regard to ARBL specifically, I like using 18 percent for the first five years and somewhere around 10 percent for the next five. I would prefer to utilize growth rates of 15% and 10%, respectively if the company under consideration is an established business that has reached a specific size (such as a large-cap corporation). Being as conservative as you can is the goal here.

Step 3: Calculate projected cash flows.

As of 2013, there was an average cash flow of Rs. 140.26 crores. The cash flow for the years 2014 and 2015 is anticipated to be – at an 18 percent growth rate.

= 140.36 * (1 + 18 %)

= Rs. 165.62 Crs.

According to estimates, the free cash flow for the years 2015 to 2016 will be.

165.62 * (1 plus 18%)

= Rs. 195.43 Crs.

Now that we know this, we can fairly forecast the free cash flow in the future. You might be wondering how trustworthy these numbers are. Since forecasting free cash flow entails forecasting revenues, expenses, business cycles, and almost every other facet of the company. The estimated future cash flow is, after all, just that—an estimate. The key here is to assume the free cash flow growth rate while remaining as conservative as you can. For the future, we have anticipated growth rates of 18 and 10 percent, which are moderate growth rates for a successfully run business.

The Terminal Value

We have made an effort to forecast free cash flow for the next 10 years. However, what would happen to the business after ten years? Would it eventually vanish? Actually, it wouldn’t. It is believed that a business would always be a “going concern.” This implies that some free cash is produced for as long as the business is in business. The rate at which free cash is generated, however, starts to slow down as businesses get older.

The “Terminal Growth Rate” is the rate of free cash flow growth after 10 years (2024 onward). The terminal growth rate is typically thought to be less than 5%. Personally, I prefer to keep this rate between 3 and 4 percent, never going above that.

The “Terminal Value” is the total of all free cash flow that will be generated after the 10th year, also known as the terminal year. We only need to multiply the cash flow from the 10th year by the terminal growth rate to determine the terminal value. However, since we are physically calculating the value to infinity, the formula to achieve this is different.

FCF * (1 + Terminal Growth Rate) / Terminal Value (Discount Rate – Terminal growth rate)

Please take note that the FCF utilized to determine the terminal value is the one from the 10th year. Let’s determine the ARBL’s terminal value using a 9 percent discount rate and a 3.5 percent terminal growth rate.

= 517.12 * (1 + 3.5%) / (9 percent – 3.5 percent )

= Rs.9731.25 Crs

The Net Present Value (NPV)

The terminal value and anticipated free cash flow for the following ten years are both known (which is the future free cash flow of ARBL beyond the 10th year and up to infinity). The worth of these cash flows in today’s dollars must now be determined. This is the current value calculation, as you may remember. We will add these present values once we have determined their present values in order to calculate the ARBL’s net present value (NPV).

The discount rate will be set at 9 percent.

For instance, ARBL is anticipated to collect Rs. 195.29 Cr. in 2015–16, which is two years from now. The present value would be – at a 9 percent discount rate.

is 195.29 / (1+9%)2.

= Rs.164.37 Crs

Additionally, we must figure out the terminal value’s net present value. We just multiply the terminal value by the discount rate to arrive at this calculation.

= 9731.25 / (1 + 9%) 10

= Rs.4110.69 Crores

As a result, the sum of the cash flow present values is equal to the net present value of future free cash flows plus the terminal value.

= 1968.14 + 4110.69

= Rs.6078.83 Crores

In other words, from where I am now and going ahead, I anticipate ARBL to generate a totally free cash flow of Rs. 6078.83 Cr., all of which would belong to the company’s stockholders.

The Share Price

The DCF analysis has reached its conclusion. On the basis of the company’s projected free cash flow, we will now determine ARBL’s share price.

We now know the estimated total free cash flow that ARBL will produce. We are also aware of the number of outstanding shares on the market. We might calculate the price per share of ARBL by dividing the total free cash flow by the entire number of shares.

But first, we have to figure out how much “Net Debt” the company has based on its balance sheet. Current year total debt less current year cash and cash balance equal current year net debt.

‘

Net Debt = Total Debt for the Current Year – Cash and Cash Balance.

This would be (according to the FY14 Balance sheet) for ARBL:

Net Debt = 75.94 – 294.5

= (Rs.218.6 Crs)

A bad omen means that the business has more cash than debt. The entire present value of free cash flows must, of course, include this.

= Rs.6078.83 Crs – (Rs. 218.6 Crs)

= Rs.6297.43 Crores

The share price of the company, also known as the company’s intrinsic value, can be calculated by dividing the aforementioned figure by the total number of shares.

Share Price is calculated as Shares Outstanding / Total Present Value of Free Cash Flow.

According to ARBL’s annual report, there are currently 17.081 billion shares outstanding. Consequently, the intrinsic value or the value per share is –

= Rs.6297.43 Crs / 17.081 Crores

~ Rs.368 per share!

This, in fact, is the final output of the DCF model.

Modeling Error & the intrinsic value band

The DCF model is predicated on a number of assumptions, despite being quite scientific. Especially in finance, assuming becomes an art form. As you continue and get more experience, you get better at it. Therefore, for all practical purposes, we should assume (yet another assumption) that we made a few mistakes when performing the intrinsic value computation. We should therefore make room for modeling inaccuracies.

Simply said, a margin for modeling error enables us to be adaptable when determining the per-share value. For what I believe to be the stock’s fundamental worth, I personally like to add a +10% upper band and a -10% lower band.

Using that to inform our calculation:

The lower intrinsic value is equal to 368 * (1- 10%), which is Rs.

additional intrinsic value=Rs.405

As a result, I would now think that the stock is fairly valued between Rs. 331 and 405, as opposed to Rs. 368 as the previous assumption. The intrinsic value band would be this.

We now check the stock’s market value while maintaining this value in context. On the basis of its current market price, we draw the following conclusions:

We deem a stock to be undervalued if its price is below the lower bound of its intrinsic value band. Therefore, one should consider purchasing the stock.
The stock is deemed to be reasonably priced if its price falls within the range of its intrinsic value. While it is not advisable to make a new purchase, it is still possible to hold onto the stock without adding to current positions.
The stock is regarded as overvalued if its price is higher than the higher intrinsic value band. At these prices, the investor has the option of taking a profit or staying put. But you should not buy at these prices.

A share of the stock is currently trading for Rs. 726.70! Much greater than the intrinsic value band’s highest limit. Buying the stock at these prices means that one is purchasing at extraordinarily high valuations, which is obvious.

Spotting buying opportunities

Long-term investments and the activities that surround them go slowly, like a locomotive train. Contrarily, active trading is comparable to a swift bullet train. When a long-term value opportunity arises, it remains in the market for some time. It doesn’t actually vanish quickly. For instance, we now understand that the current market price of Amara Raja Batteries Limited is excessive. Trading is much above the intrinsic value band’s upper bound. But a year ago, the situation was entirely different. Remember that ARBL’s intrinsic value ranges from Rs. 331 to Rs. 405 depending on the FY 2013–2014.

The stock traded comfortably within the band for almost five months, as evidenced by the blue accent. The stock was available for purchase for the entire year. All you had to do after purchasing was wait for the returns to arrive!

Actually, it is for this very reason that it is said that bear markets produce value. The markets remained gloomy during the entire year 2013 and provided excellent purchasing opportunities in high-quality equities.

Conclusion

Three chapters ago, we looked at many facets of equity research. Equity research is just the act of examining the company from three various angles, as you may have guessed (stages).

Stage 1 involved examining the company’s qualitative features. We have now established the who, what, when, how, and why of the business. I see this level of equity research as being absolutely vital. I don’t move on if something in this is not very convincing. Markets are an ocean of possibility, so resist the urge to force yourself to commit to one that does not feel right.

Only when I am completely satisfied with my results from stage 1, do I move on to stage 2. Stage 2 is essentially the implementation of the typical checklist, where we assess the performance of the business. The checklist we’ve discussed is simply my interpretation of what, in my opinion, is a rather reasonable checklist. I would advise you to create your own checklist, but make sure each item is supported by a sound argument.

I go on to stage three of the equity research process if the business passes stages one and two. In stage 3, we assess the intrinsic value of the stock and contrast it with its market value. A stock is said to be good if it is trading for less than its intrinsic value.

You will undoubtedly be convinced to acquire the stock after all three stages coincide with your delight. Once you’ve made a purchase, hold onto it, don’t worry about the daily volatility (which is actually a benefit of capital markets), and let the market develop naturally.

Please take note that I constructed a DCF Model using Excel and have included it on ARBL. This calculator is available for download and can be used by other businesses as well.

CONCLUSION

1. Equity Research for Limited Resources can be carried out in three steps.

1. Knowledge of the Business

2. the use of the checklist

3. Valuations

2. To achieve stage 1’s goal of understanding the business, we must compile all relevant business data. The Q&A method is the most effective strategy here.

3. In the Q&A format, we start by submitting a few uncomplicated queries for which we can discover solutions.

4. We should be finished with all business-related information by the time we complete stage 1 of the process.

5. The majority of the answers needed for stage 1 are available on the company’s website and annual report.

6. Do you recall that during stage one of researching the firm, it is frequently a good idea to suspend further investigation if there is something that is not very convincing about the organization?

7. In stage 1, you must get persuaded (based on facts) about the business. This is how you will strengthen your resolve to hold onto your investments during bear markets.

8. You must assess the company’s success in Stage 2 of the equity research process on a number of different fronts.

9. After the company passes stages 1 and 2 only then will you move on to stage 3.

10. By subtracting capital expenses from net cash from operating activities, the company’s free cash flow (FCF) is determined.

11. The amount of money left over for investors is tracked by free cash flow.

12. To predict the cash flow for the coming year, the most recent FCF is used.

13. The FCF must be grown at a conservative pace of growth.

14. When the company’s cash flow is anticipated to increase after the terminal year, this is known as the terminal growth rate.

15. The worth of the company’s cash flow from the terminal year up to infinity is what is known as the terminal value.

16. The terminal value must be discounted back to today’s value along with the future cash flow.

17. The total net present value of cash flows is the total discounted cash flows plus the terminal value.

18. The net debt must be subtracted from the sum of the net present values of the cash flows. We may calculate the company’s per-share value by dividing this amount by the total number of shares.

19. By adding a 10% range around the share price, one must account for modeling inaccuracies.

20. We define an intrinsic value band by adding a 10% tolerance.

21. The stock price above the intrinsic value band is regarded as pricey, while the stock price within the range is regarded as a good buy.

22. Long-term ownership of inexpensive stocks generates wealth.

23. As a result, the DCF analysis aids investors in determining if the current share price of the company is appropriate.

Investment Due Diligence

October 4, 2022August 1, 2022 by Bala gumber

Fundamental Analysis

• Introduction
• Investor’s mindset
• Annual report reading
• P&L statement
• Balance sheet
• The cash flow

• The financial ratio
• Investment due diligence
• Equity research
• DCF primer
• Notes

12.1 – Taking stock

Firstly, We learned how to interpret financial accounts and compute a few crucial financial ratios during the course of the previous chapters. The eventual goal of this module has its roots in these chapters: – to choose the equities to invest in using fundamental analysis. If you recall, we talked about the characteristics of investable grades in the prior chapters. The conditions for a company that must be verified before making an investment choice are defined by its investable grade features. Consider the investable grade characteristics as a checklist based on the company’s fundamentals. A business is deemed investment-worthy if it checks off the majority of the checklist’s requirements.

Here are a few areas where there are variations. For instance, you might not place as much importance on an attribute that I would consider an investable grade. For instance, although I may choose to pay close attention to corporate governance, another investor may choose to pay less attention. He might dismiss it by saying, “All businesses have some murky areas, but as long as the statistics add up, I’m okay with investing in the business.”

The key idea is that there is no set checklist. Based on his prior financial expertise, each investor must create his or her own checklist. But one must make sure that each item on the checklist is justified by reason. I’ll give a checklist that I believe is relatively well-curated later in this chapter. If you are starting from scratch, you could get some advice from this list. As we continue with this subject, we will use this checklist as a guide.

12.2-Generating a stock idea

Now, before we continue and create a checklist, we need to deal with a more fundamental problem. Choosing an intriguing stock is the first step in the investment process. After choosing the stock, we must check it against the checklist to see if it satisfies all the requirements. If so, we must invest, and if not, we must explore alternative alternatives.

So how do we choose a stock that appears appealing in the first place? How can we create a list of stocks that look worthwhile enough to research further, in other words? There are a number of ways to accomplish this, including:

General Observation: Although it may seem elementary, this is one of the best methods for creating a stock idea. All you have to do is pay attention to the economic activities around you by keeping your eyes and ears open. Keep an eye out for what individuals are purchasing and selling, what things are being consumed, and what topics are being discussed in the area. In his book “One up on Wall Street,” one of the most renowned Wall Street investors, Peter Lynch, actually recommends this strategy. Personally, I have applied this strategy to some of my investments, including PVR Cinemas Ltd., Cummins India Limited, and Info Edge Limited. I chose these companies because I noticed the proliferation of PVR multiplexes in the City, Cummins diesel generators in most of the buildings, and PVR Cinemas Ltd. (Info Edge owns naukri.com, which is probably the most preferred job portal).

Stock screener – A stock screener assists in finding stocks based on the criteria you provide and enables investors to do a thorough stock analysis. For instance, you can use a stock screener to find stocks with a 25 percent ROE and a 20 percent PAT margin. When you wish to select a small number of investment ideas from a large pool of potential investments, a stock screener is a useful tool. There are other stock screeners accessible; however, my personal favorite is the stock screener and screener on Google Finance. In.

Macro Trends – Keeping an eye on the macroeconomic trend, in general, is a terrific approach to spot high-quality stocks. Here is an example of the same: At the moment, India is pushing hard for infrastructural projects. Cement businesses operating in India would clearly benefit from this effort. So, in order to determine which cement companies are best positioned to take advantage of this macro trend, I would search through all of the cement companies and use the checklist.

Sector-specific trends are covered by this. To find developing trends and businesses inside the sector that can profit from them, one needs to monitor sectors. For instance, the market for non-alcoholic beverages is a fairly established industry. Coffee, tea, and bottled water are the three main product categories. As a result, the majority of businesses only produce and market these three items. However, there has recently been a small change in consumer preferences; a promising new market for energy drinks is emerging. As a result, the investor can look for businesses in the industry that is best positioned to benefit from and adjust to this transition.

Special Situation: This method of coming up with a stock concept is a little more difficult. For the purpose of coming up with an idea based on a unique circumstance, one must watch businesses, company-related news, corporate events, etc. One instance that comes to mind immediately is Cox & Kings. You may be aware that Cox & Kings is one of the oldest and largest travel operators in India. Mr. Keki Mistry (from HDFC Bank) joined the company’s advisory board in late 2013. Corporate India has a great deal of respect for him because he is regarded as a very ethical and effective businessperson. A coworker of mine was certain that having Mr. Keki Mistry on the board of Cox & Kings would be beneficial. This alone served as the main impetus for my colleague to look into the stock more. After more investigation, my colleague made a happy investment in Cox & Kings Limited. Good for him, I know he is sitting on a 200 percent gain as I type this.

Circle of Competence: Use this to uncover potential stock ideas by utilizing your professional expertise. For a beginner investor, this strategy comes highly recommended. You must identify stocks using this strategy within the context of your line of work. If you work in medicine, for instance, your competence circle would include the healthcare sector. You are more likely to be knowledgeable about that sector than a stockbroker or an equities research analyst.

All you have to do is locate the listed businesses in this industry and select the top ones based on your evaluation. Similar to this, if you work in banking, you probably know more about banks than anyone else. Utilize your network of expertise to choose your investments.

The key idea is that any source could serve as the impetus for researching stocks. In fact, add stocks to your list as and when you think they appear interesting. Your “watch list” will eventually be this list. It’s important to note that while a stock may not meet the checklist items right now, as time goes on and company conditions evolve, it may eventually line up with the criteria. As a result, it’s crucial to periodically assess the stocks on your watch list.

12.3 – The Moat

One must use the checklist after choosing a stock to further research it. “Investment due diligence” refers to this. One must give every part of the due diligence procedure the utmost attention because it is so important. I’ll soon give a checklist that I believe is fair. However, we must first discuss “The Moat”.

The word “moat” (sometimes known as an “economic moat”) was made popular by Warren Buffet. The phrase describes the firm’s competitive advantage (over its competitors). Strong moats ensure that a company’s long-term profits are protected. Of course, the business should be able to survive for a very long time in addition to having a moat. A business would be more sustainable if it possessed a larger range of moat qualities, such as a stronger brand identity, greater pricing power, and greater market share. It would be challenging for the business’ competitors to reduce its market share.

Consider “Eicher Motors Limited” in order to comprehend moats. A significant Indian automaker is Eicher Motors. Along with the recognizable Royal Enfield bikes, it also produces commercial vehicles. There is a sizable fan base for Royal Enfield motorcycles both inside and outside of India. Its brand memory is extremely strong. Royal Enfield serves a rapidly expanding niche market. Their motorcycles are neither as cheap as TVS motorcycles nor as pricey as Harley Davidson motorcycles.

It would be difficult for any competitor to enter this market and undermine the support that consumers have for Royal Enfield. In other words, it will take a lot of work from its rivals to push Eicher Motors out of this sweet place. One of Eicher Motors’ moats is this.

Many businesses display these fascinating moats. In actuality, a sustained moat is one of the fundamental components of great wealth-creating businesses. Consider Infosys, whose competitive advantage was labor arbitrage between the US and India, Page Industries, which had the manufacturing and distribution rights to Jockey undergarments, Prestige Industries, which produced and sold pressure cookers, Gruh Finance Limited, which had small ticket size credits distributed to a particular market segment, and so on. Decide to always invest in businesses that have wider economic moats.

12.4 – Due Diligence

The following steps are included in the equity research due diligence process:

Reading the yearly reports is necessary for understanding the business.
utilize the checklist, and
Estimating the business’s intrinsic value is known as valuation.

In step 1, “understanding the business,” we go deeply into the industry to get to know the business from top to bottom. The questions that need responses must be compiled into a list. Posting a basic inquiry about the company, such as “What business is the company involved in,” might be a nice place to start.

Instead of using Google to seek for the solution, we look for it on the company’s website or in the most recent Annual Report. This clarifies what the business has to say about itself.

When it comes to my own investing strategy, I often prefer to invest in businesses where there is little to no government interference and little to no competition. For instance, there were only 3 listed competitors in that market when I made the decision to invest in PVR Cinemas. INOX, Cinemax, and PVR. Two publicly traded companies remain in that industry following the merger of PVR and Cinemax. However, a few new firms have recently entered this market. So it’s time for me to reconsider my PVR investment idea.

When we feel confident about our knowledge of the industry, we go to stage 2 or use the checklist. We now receive some performance-related responses.

Finally, even if a business checks every item on the checklist above, buying its stock makes little sense if it is not trading at a fair price. How can we determine whether the stock is trading at the appropriate price or not? Well, this is what stage 3 entails. We must perform a stock valuation exercise. The “Discounted Cash Flow (DCF) Analysis” is the most used method of valuation.

We will go over the foundation for conducting formal research on the company in the next chapters. It is known as “Equity Research.” Our discussion of equity research will be mostly centered on Stages 2 and 3, as I believe Stage 1 entails reading the annual report quite thoroughly.

CONCLUSION

Any source can provide a stock concept.
It is a good idea to keep a watch list of stocks that you find intriguing.
After a stock has been located, we ought to search for sustainable moats.
Understanding the business, going through the checklist to understand its financial performance, and performing the valuation exercise is all part of the due diligence process.
One should be entirely comprehensive with the business operation of the organization when it comes to knowing the business.
As the investor gets to experience it, the checklist should be adjusted accordingly.
One of the greatest methods for determining the business’s intrinsic worth is the DCF approach.

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Let's get to the Maths

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The correlation between Major and Minor

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Conclusion

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CONCLUSION

Options

5.1 – Getting the orientation right

5.2 – Building a case for a Put Option buyer

5.3 – Intrinsic Value (IV) of a Put Option

5.4 – P&L behavior of the Put Option buyer

5.5 – Put option buyer’s P&L payoff

CONCLUSION

Options

4.1 – Two sides of the same coin

4.2 – Call option seller and his thought process

4.3 – Call Option seller pay-off

4.4 – A note on margins

4.5 – Putting things together

4.6 – European versus American Options

CONCLUSION

Options

3.1 – Buying call option

3.2 – Building a case for a call option

3.3 – Intrinsic value of a call option (upon expiry)

3.4 – Generalizing the P&L for a call option buyer

3.5 – Call option buyer’s payoff

CONCLUSION

Options

2.1– Decoding the basic jargons

CONCLUSION

Options

1.1– Breaking the Ice

1.2 – A Special Agreement

1.3 – The Call Option

CONCLUSION

Fundamental Analysis

14.1 – The Stock Price

14.2 – The future cash flow

The DCF model’s central idea is future cash flow. A straightforward example will allow us to comprehend this.

George, a buddy of his, is a big fan of Vishal’s pizza maker. George offers to buy it because it is so bad.

Especially, I was hoping you could take notice that I’ve assumed the machine will begin producing money in 2015 out of convenience.

It is obvious that George will make Rs. 50,000,00 during the course of the following ten years, after which the machine will be useless. At this point, one thing is certain: whatever the price of this gadget is, it cannot be higher than Rs. 50,000,000.

Consider whether it makes sense to pay a price that exceeds the economic advantage that an entity provides.

We have determined three significant pieces of information thus far in our attempt to determine the pricing of the robotic pizza maker:

First of all, Over the following ten years, the pizza company will generate Rs. 50,000,00 in total cash flow.

secondly, Since the whole cash flow is known, it also follows that the cost of the machine should be lower than the cash flow it generates overall.

Thirdly, The investment option of earning 8.5 percent interest is the opportunity cost of purchasing the pizza machine.

Let’s continue while keeping the aforementioned three things in mind. Now let’s concentrate on cash flows. We are aware that George will profit from the machine for the following ten years, earning Rs. 500,000 years. Consider this: George is looking toward the future in 2014.

What is the current value of the Rs. 500,000 that he will receive in 2016?

What is the current value of the Rs. 500,000 that he would receive in 2018?

What is the current value of the Rs. 500,000 that he will receive in 2020?

How much, on average, is the present value of the future cash flow?

Surely, These questions can be answered by considering the “Time value of money.” In other words, I would be in a better position to price that machine if I could determine the value of all the projected cash flows from it in terms of today’s value.

Apart From this, Please be aware that in the section after this one, we will depart from the pizza issue.

14.3 – Time Value of Money (TMV)

For that reason, I will give you the formula needed to compute the FV and PV without going into the really easy maths involved.

Example 1: Assuming an opportunity cost of 8.5 percent, what is Rs. 5000/- worth in 2014 dollars five years from now?

We are attempting to determine the future value of the money we currently possess, which is a case of future value (FV) computation.

Future Value = Amount * (Opportunity Cost Rate + 1) Age in years.

= 5000 * (1% plus 8.5%) 5

= 7518.3

This suggests that assuming an opportunity cost of 8.5 percent, Rs. 5000 today is equivalent to Rs. 7518.3 after 5 years.

Example 2: Assuming an opportunity cost of 8.5 percent, how much is Rs. 10,000/- in receivables worth today?

As we attempt to calculate the present value of future cash receipts in terms of today’s value, this is unmistakably a case of present value (PV) computation.

Amount / (1+Discount Rate) Equals Present Value Ages in years

10,000 divided by 1 plus 8.5% ^ 6

**Future Value = Amount * (Opportunity Cost Rate + 1) Age in years.**