• 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
• All volatility
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:
The answer is as follows:
= 6.35 – Max [0, (2023 – 2050)]
= 6.35 – Max [0, -27]
= 6.35 – 0
The resolution fits Generalization 1 (profit restricted to the extent of the premium received).
= 6.35 – Max [0, (2072 – 2050)]
= 6.35 – 22
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)
= 6.35 – Max [0, (2055 – 2050)]
= 6.35 – Max [0, +5]
= 6.35 – 5
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
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.”
- 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.