What is a call and put options?

What is a Call Option?

We are going to understand the call option with an example.

Assume a stock is trading at Rs.97/- today. You are given a right today to buy the same one month later, at say Rs. 105/-, but only if the share price on that day is more than Rs. 105, would you buy it?. Obviously you would, as this means to say that after 1 month even if the share is trading at 125, you can still get to buy it at Rs.105!

In order to get this right you are required to pay a small amount today, say Rs.10/-.

If the share price moves above Rs. 105, you can exercise your right and buy the shares at Rs. 105/-. If the share price stays at or below Rs. 105/- you do not exercise your right and you do not need to buy the shares.

All you lose is Rs. 10/- in this case. An arrangement of this sort is called Option Contract or simply a ‘Call Option'.

 

Call Option

Possibilities of the Agreement

After you get into this agreement, there are only three possibilities that can occur. And they are-

• The stock price can go up, say Rs.125/-
• The stock price can go down, say Rs.90/-
• The stock price can stay at Rs.105/-

If the stock price goes up, then it would make sense in exercising your right and buy the stock at Rs.105/-.

The P&L would look like this –

• Price at which stock is bought = Rs.105
• Premium paid =Rs. 10
• Expense incurred = Rs.(10 +105 = 115)
• Current Market Price = Rs.125
• Profit = 125 – 115 = Rs.10/-

Buy Happily!

If the stock price goes down to say Rs.90/-

The P&L would look like this –

• Price at which stock is bought = Rs.105
• Premium paid =Rs. 10
• Expense incurred = Rs.(10 +105 = 115)
• Current Market Price = Rs. 90
• Loss = 115 – 90 = Rs. 25/-

Let it go!

If the stock stays flat at Rs.105/-

The P&L would look like this –

• Price at which stock is bought = Rs.105
• Premium paid =Rs. 10
• Expense incurred = Rs.(10 +105 = 115)
• Current Market Price = Rs. 105
• Loss = 115 – 105 = Rs. 15/-

Let it go!

What is a Put Option?

Now, think of a put option as an insurance policy.

If you own your car, you are likely familiar with purchasing Car insurance.

A Car owner buys a Car policy to protect their car from damage.

They pay an amount called the premium, for some amount of time, let’s say a year.

The policy has a face value and gives the insurance holder protection in the event the car is damaged.

What if, instead of a car, your asset was a stock or index investment?

Similarly, if an investor wants insurance on his/her Nifty50 index portfolio, they can purchase put options when the investor fears that a bear market is near.

For example, If I have huge shares of TCS in my portfolio. Now my analysis says TCS may drop drastically due to some reason. I have to protect my investment. For that purpose I will go for put buying. People use this instrument for hedging . However many people also go for naked buying of Put option when they believe particular share will fall.

I will bring more things of Option. Keep moving with me.

Happy Trading!