A beginners guide to call options trading

Karthik Rangappa

The options market makes up for a significant part of the derivative market, particularly in India. I would not be exaggerating if I were to say that nearly 80 percent of the derivatives traded are options and the rest is attributable to the futures market.

Internationally, the options market has been around for a while now. Though the options market has been around since 2001, the real liquidity in the Indian index options was seen only in 2006!

I remember trading options around that time, the spreads were high and getting fills was a big deal. However, in 2006, the Ambani brothers formally split up and their respective companies were listed as separate entities, thereby unlocking the value to the shareholders.

In my opinion, this particular corporate event triggered vibrancy in the Indian markets, creating some serious liquidity. However, if you were to compare the liquidity in Indian stock options with the international markets, we still have a long way to catch up.

A special agreement

There are two types of options: call and put.

You can be a buyer or seller of these options. Based on what you choose to do, the P&L profile changes. Of course, we will get into the P&L profile at a much later stage.

For now, let us understand what the call option means. In fact, the best way to understand the call option is to first deal with a tangible real-world example, once we understand this example we will extrapolate the same to stock markets. So let’s get started.

Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued at Rs 500,000. Ajay has been informed that in the next 6 months, a new highway project is likely to be sanctioned near the land that Venu owns.

If the highway indeed comes up, the valuation of the land is bound to increase and therefore Ajay would benefit from the investment he would make today.

If the highway news turns out to be a rumour - which means Ajay buys the land from Venu today and there is no highway tomorrow, then Ajay would be stuck with a useless piece of land!

So what should Ajay do?

This situation has put Ajay in a dilemma as he is uncertain whether to buy the land from Venu or not. While Ajay is muddled in this thought, Venu is quite clear about selling the land if Ajay is willing to buy.

Ajay wants to play it safe, he thinks through the whole situation and finally proposes a special structured arrangement to Venu, which Ajay believes is a win-win for both of them, the details of the arrangement is as follows –

1. Ajay pays an upfront fee of Rs 100,000 today. Consider this as non-refundable agreement fees that Ajay pays


2. Against this fees, Venu agrees to sell the land after 6 months to Ajay


3. The price of the sale (which is expected 6 months later) is fixed today at Rs 500,000


4. Because Ajay has paid an upfront fee, only he can call off the deal at the end of 6 months (if he wants to that is), Venu cannot


5. In the event Ajay calls off the deal at the end of 6 months, Venu gets to keep the upfront fees

What do you think about this special agreement? Who do you think is smarter here – Is it Ajay for proposing such a tricky agreement or Venu for accepting such an agreement?

The answer to these questions is not easy, unless you analyse the details of the agreement thoroughly. I would suggest you read through the example carefully (it also forms the basis to understand options) – Ajay has plotted an extremely clever deal here! In fact, this deal has many faces to it.

Let us break down Ajay’s proposal to understand some details:

• By paying an agreement fee of Rs 100,000, Ajay is binding Venu into an obligation. He is forcing Venu to lock the land for him for the next 6 months


• Ajay is fixing the sale price of the land based on today’s price i.e. Rs 500,000 which means irrespective of what the price would be 6 months later he gets to buy the land at today’s price. Do note, he is fixing a price and paying an additional Rs 100,000 today


• At the end of the 6 months, if Ajay does not want to buy the land he has the right to say ‘no’ to Venu, but since Venu has taken the agreement fee from Ajay, Venu will not be in a position to say no to Ajay


• The agreement fee is non-negotiable, non-refundable

After initiating this agreement both Ajay and Venu have to wait for the next 6 months to figure out what would actually happen. The price of the land will vary based on the outcome of the ‘highway project’. However irrespective of what happens to the highway, there are only three possible outcomes –

1. Once the highway project comes up, the price of the land would go up, say it shoots up to Rs 10,00,000


2. The highway project does not come up, people are disappointed, the land price collapses, say to Rs 300,000


3. Nothing happens, the price stays flat at Rs 500,000

We will now step into Ajay’s shoes and think through what he would do in each of the above situations.

Scenario 1: Prices rise to Rs 10,00,000

Since the highway project has come up as per Ajay’s expectation, the price of the land has also increased. Remember as per the agreement, Ajay has the right to call off the deal at the end of 6 months.

Now, with the increase in the land price, do you think Ajay will call off the deal? Not really, because the dynamics of the sale are in Ajay’s favour:

Current market price of the land: Rs 10,00,000

Sale agreement value: Rs 500,000

This means Ajay now enjoys the right to buy a piece of land at Rs 500,000 when in the open market the same land is selling at a much higher value of – Rs 10,00,000.

Ajay is making a steal here. He would go ahead and demand that Venu to sell him the land. Venu is obligated to sell him the land at a lesser value, simply because he had accepted Rs 100,000 agreement fees from Ajay 6 months earlier.

So how much money is Ajay making? Well, here is the math:
Buy price: Rs 500,000
Add: Agreement fees: Rs 100,000 (remember this is a non-refundable amount)
Total expense = Rs 500,000 + Rs 100,000 = Rs 600,000
Current market price of the land: Rs 10,00,000

Hence his profit is Rs 10,00,000 – Rs 600,000 = Rs 400,000

Another way to look at this is – For an initial cash commitment of Rs 100,000 Ajay is now making 4 times the money! Venu even though very clearly knows that the value of the land is much higher in the open market, is forced to sell it at a much lower price to Ajay.

The profit that Ajay makes (Rs 400,000) is exactly the notional loss that Venu would incur.

Scenario 2: Price goes down to Rs 300,000

It turns out that the highway project was just a rumour, and nothing really is expected to come out of the whole thing. People are disappointed and hence there is a sudden rush to sell out the land. As a result, the price of the land goes down to Rs 300,000.

So what do you think Ajay will do now? It does not make sense to buy the land, hence he would walk away from the deal. Here is the math that explains why it does not make sense to buy the land –

Remember the sale price is fixed at Rs 500,000, 6 months ago. If Ajay has to buy the land he has to shell out Rs 500,000 and Rs 100,000 paid towards agreement fees.

Which means he is in effect paying Rs 600,000 to buy a piece of land worth just Rs 300,000. Clearly, this would not make sense to Ajay, since he has the right to call off the deal, he would simply walk away from it and would not buy the land. However do note, as per the agreement Ajay has to let go of Rs 100,000, which Venu gets to pocket.

Scenario 3: Price stays at Rs 500,000

For whatever reasons after 6 months the price stays at Rs 500,000 and does not really change. What do you think Ajay will do? Well, he will obviously walk away from the deal and would not buy the land. Why you may ask, well here is the math –

Cost of land: Rs 500,000
Agreement fee: Rs 100,000
Total: Rs 600,000

Value of the land in open market: Rs 500,000

It does not make sense to buy a piece of land at Rs 600,000 when it is worth Rs 500,000. Since Ajay has already committed Rs 1 lakh, he could still buy the land, but ends up paying Rs 1 lakh extra in this process.

For this reason, Ajay will call off the deal and in the process let go of the agreement fee of Rs 100,000 (which Venu obviously pockets).

I hope you have understood this transaction clearly, and if you have then it is good news as through the example you already know how the call options work!

But, let us not hurry to extrapolate this to the stock markets; we will spend some more time with the Ajay-Venu transaction.

Here are a few Q&A’s about the transaction which will throw some more light on the example:

Why do you think Ajay took such a bet even though he knows he will lose his Rs 1 lakh if land prices do not increase or stay flat?

Agreed Ajay would lose Rs 1 lakh, but the best part is that Ajay knows his maximum loss is Rs 1 lakh. There are no negative surprises for him. As and when the land prices increases, so would his profits (and therefore his returns). At Rs 10,00,000 he would be earning Rs 400,000 on his investment of Rs 100,000 which is 400 percent.

Under what circumstances would a position such as Ajay’s make sense?

Only in a scenario when the price of land increases.

Under what circumstances would Venu’s position makes sense?

Only if the price of the land decreases or stays flat.

Why do you think Venu is taking such a big risk? He would lose a lot of money if land prices increase after 6 months?

There are only 3 possible scenarios, of which 2 indeed benefit. Statistically, Venu has a 66.66 percent chance of winning the bet as opposed to Ajay’s 33.33 percent chance. Let us summarise a few important points now:

The payment from Ajay to Venu ensures that Ajay has a right (remember only he can call off the deal) and Venu has an obligation (if the situation demands, he has to honour Ajay’s claim).

The outcome of the agreement at termination (end of 6 months) is determined by the price of the land. Without the land, the agreement has no value.

The land is therefore called an underlying and the agreement is called a derivative.

An agreement of this sort is called an options agreement.

Since Venu has received an advance from Ajay, Venu is called the agreement seller or writer and Ajay is called the agreement buyer.

Since this agreement is called an options agreement, Ajay can be called an options buyer and Venu the options seller/writer.

The agreement is entered after the exchange of Rs 1 lakh, hence Rs 1 lakh is the price of this option agreement. This is also called the premium amount.

Every variable in the agreement: area of the land, price and the date of sale is fixed.

As a thumb rule, in an options agreement, the buyer always has a right and the seller has an obligation.

Let us now proceed to understand the same example from a stock market perspective.

The call option:

I will deliberately skip the nitty-gritty of an option trade at this stage. The idea is to understand the bare bone structure of the call option contract.

Assume a stock is trading at Rs 67 today. You are given a right today to buy the same one month later, at say Rs 75, but only if the share price on that day is more than Rs 75, would you buy it?

Obviously, you would as after 1-month even if the share is trading at Rs 85 you can still get to buy it at Rs 75!

In order to get this right, you are required to pay a small amount today, say Rs 5. If the share price moves above Rs 75 you can exercise your right and buy the shares at Rs 75.

If the share price stays at or below Rs 75 you do not exercise your right and you do not need to buy the shares. All you lose is Rs 5 in this case. An arrangement of this sort is called an option contract, a call option to be precise.

After you get into this agreement, there are only three possibilities that can occur. They are:

1. The stock price can go up, say Rs 85


2. The stock price can go down, say Rs 65


3. The stock price can stay at Rs 75

Case 1: If the stock price goes up, then it would make sense in exercising your right and buy the stock at Rs 75. The P&L would look like this:
Price at which the stock is bought: Rs 75
Premium paid: Rs 5
Expense incurred: Rs 80
Current market price: Rs 85

Profit: Rs 85 – Rs 80 = Rs 5

Case 2: If the stock price falls to Rs 65 it does not make sense to buy it at Rs 75 as effectively you would be spending Rs 80 (75+5) for a stock that is available at Rs 65 in the open market.

Case 3: If the stock stays flat at Rs 75 it simply means you are spending Rs 80 to buy a stock which is available at Rs 75, hence you would not invoke your right to buy the stock at Rs 75.

This is simple right? If you have understood this, you have essentially understood the core logic of a call option. What remains unexplained is the finer points, all of which we will learn soon.

If you have understood this, you have essentially understood the core logic of a call option. What remains unexplained is the finer points, all of which we will learn soon.

Whenever you expect the price of a stock (or any asset for that matter) to increase, it always makes sense to buy a call option!

Finally, before I end this article, here is a formal definition of a call options contract:

“The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or writer) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right”.

Disclaimer: The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.