Simplifying Call Option – By Prof. Simply Simple TM I hope the last lesson on ‘Options’ helped you in getting to understand the concept. In continuation.

Simplifying Call Option– By Prof. Simply Simple TM

I hope the last lesson on ‘Options’ helped you in getting to understand the concept.

In continuation of that, we also discussed the ‘Put’ option for your clarity on the subject.

Having explained the ‘Put’ option, quite naturally, you’ll want to know about the ‘Call’ option.

Let me try & explain it in the next few slides…

Let’s look at the same example for the farmer & bread manufacturer as we did in our earlier lessons on ‘Futures’ &

on ‘Options’.

So going back to our farmer who cultivates

wheat…

And a bread manufacturer who needs wheat as an input for making

bread…

• The farmer thinks that the price of wheat

which is currently trading at Rs. 100 could

fall to Rs. 90 in 3 months.

• The bread manufacturer on the other hand

feels that the price of wheat on the other

hand might become Rs. 120 in 3 months.

• In such a case, both of them get together & sign

a contract which says that at the end of 3

months the bread manufacturer would buy

wheat from the farmer at Rs. 110.

• Thus the bread manufacturer is protected

against a possible rise in prices.

• And the farmer is protected against any drop in

the price of wheat in the near future.

Such a contract is called a Futures

contract as we saw in our lesson on ‘Futures’.

• In a Futures contract both parties are obliged to

honor the contract and there is no escape route for

either party.

• But what if the contract gives the bread

manufacturer the “option” of (either)

– Buying the wheat from the farmer at the pre-

agreed price of Rs 110 (or)

– Choosing to exit the contract and buy wheat from

the open market at the prevailing market price?

• In other words, the bread manufacturer is given the

option of not honoring the contract made with the

farmer on the date of settlement.

Such a contract that gives the bread

manufacturer the option of either executing the contract or exiting it is known as an ‘Options’

Contract.But the bread

manufacturer cannot get this privilege just like

that. He obviously has to pay a premium for

exercising this facility…

• Now, let’s say that after 3 months the price of

wheat falls to Rs. 90.

• In this case the bread manufacturer quite

clearly would want to exit the contract so that

he is free to buy wheat from the open market

for Rs. 90.

• If so, while the bread manufacturer gets away,

the farmer is left high and dry and has no other

option but to sell his produce in the open

market at Rs 90.

• But it is that bad a situation for the farmer as it appears as

he gets compensated by the bread manufacturer for

having been a party to the ‘Options’ contract.

• This compensation * in the form of price is called the

“Option Premium” that the bread manufacturer has to pay

for the Options contract and is usually a small amount.

• Let’s assume in our case the amount is Rs 5.

• So the bread manufacturer is obliged to pay the farmer Rs

5 as he has chosen to opt out of the contract.

* Please note that the bread manufacturer will have to pay an option premium regardless of whether or not the option is actually exercised.

• Thus although the farmer has no other option left

but to go to the open market and sell wheat at Rs.

90, he does get the benefit of Rs 5 as

compensation for being a party to the ‘Options’

contract.

• So even if the price is Rs. 90 in the open market,

for him the effective price turns out to be

Rs. (90+5) = Rs 95

• So by simply participating in the contract he too

stands to gain something.

• For the bread manufacturer, it is a win–win

scenario by participating in the contract.

• Had the prices risen to Rs 120 as he had

anticipated, he would have executed the Options

contract at Rs 110 and would have got protected.

• But since prices fell to Rs 90 he chose to exit the

contract. Thus he is blessed with the ‘Option’ of

either executing or not executing the contract

based upon the price in the open market at the

time of contract settlement.

• It is important to understand that in an ‘Options’

contract, only one party gets the privilege to exercise

the option while the other party is obliged to honor

the option if it is chosen.

• Thus, in our case, the bread manufacturer has the

option to either execute or exit the contract whereas

the farmer is obliged to honour the decision of the

bread manufacturer.

• A contract such as this where only the purchaser of

the commodity gets the option to either exercise or

exit the contract is known as ‘Call’ option.

You will recall we had studied the ‘Put’ option

in our last lesson.Hope this explanation

has clarified the difference between the ‘Put’ and ‘Call’ option.

Basically in the ‘Put’ option the choice of

honoring the contract was with the farmer or

seller while in the ‘Call’ option this

option was with the bread manufacturer or

purchaser.

• Even in an Options contract both parties land up

achieving their goals and their interests are protected.

• The bread manufacturer stands to gain the most by

getting to exercise a choice that benefits him the most.

• The farmer on the other hand too benefits by being a

party to the contract due to the compensation he

receives from the bread manufacturer for not executing

the contract.

• The farmer due to the compensation sells the wheat in the open market at an effective price of Rs. 95

• And hence is better off than the ordinary or spot seller who would have to sell at Rs 90.

• Thus in a sense both parties landed up getting some gains by being parties to the ‘options contract’.

• However unlike in a ‘Futures’ contract, in the ‘Options’ contract one party gains more than the other party.

To Sum Up

• In a ‘Futures Contract’ both parties are obliged to honor the contract.

• In an ‘Options Contract’ one of the parties is given the privilege to exit the option on settlement date and the party has to oblige.

• In a ‘Put’ option this privilege is given to the seller (in our example - the farmer)

• In a ‘Call’ option this privilege is given to the buyer (in our example - the bread manufacturer)Copyright © 2009

Please do let me know if I have managed to clear the concepts of ‘Call Option’ as well as the difference between

‘Call’ & ‘Put’ Options.

Your feedback is very important as it helps me plan my future lessons.

Hence please give your feedback at [email protected]