Simplifying Call Option– By Prof. Simply Simple TM
Let‟s look at the same example for the farmer & breadmanufacturer 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 aninput 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 aFutures 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 manufacturercannot 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 hasclarified the difference between the „Put‟ and „Call‟ option.
Basically in the „Put‟ option the choice of honoring thecontract 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.
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@example.com
Disclaimer The views expressed in these lessons are for information purposes only and do not construe to be of any investment, legal or taxation advice. They are not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk and Tata Asset Management Ltd. will not be liable for the consequences of any such action.Mutual Fund investments are subject to market risks, read all scheme related documents carefully.