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:

1. Ajay makes a one-time payment of Rs. 100,000 today. Consider this to be Ajay’s non-refundable agreement fee.
2. In exchange for these monies, Venu consents to sell the land to Ajay after six months.
3. The sale price, which is anticipated to take place in six months, has been set at Rs. 500,000.
4. Only Ajay can cancel the agreement after six months because he paid an upfront fee; Venu is unable to do so.
5. 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:

1. The cost of the land would increase once the highway building was underway, perhaps soaring to Rs. 10,000,000.
2. People are disappointed when the highway project is abandoned and the price of land drops to, say, Rs. 300,000.
3. 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:

1. 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?

1. only in the event that the cost of the land rises

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

1. 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?

1. 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.