Very Simple Illustration of a Call Option on a stock

Very Simple Illustration of a Call Option on a stock


In the Indian market, Options cannot be sold or purchased on any and every stock. SEBI has permitted Options trading on only certain stocks that meet its stringent criteria. These stocks are chosen from amongst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis, amongst other technical criteria.
Suppose the AGM of RIL is due to be held shortly and you believe that an important announcement will be made at the AGM. While the share is currently quoting at Rs 950, you feel that this announcement will drive the price upwards, beyond Rs 950. However, you are reluctant to purchase Reliance in the cash market as it involves too large an investment and you would rather not purchase it in the futures market as futures leave you open to an unlimited risk, in case the market goes against you. Yet you do not want to lose the opportunity to benefit from this rise in price due to the announcement and you are ready to stake a small sum of money to rid yourself of the uncertainty. An Option is ideal for you. Depending on what is available in the Options market, you may be able to buy a Call Option of Reliance at a strike price of 970, although the spot price is Rs 950 at present, by paying a premium of Rs 10 per share. The total premium that you will have to pay is Rs 6,000, since one contract of Reliance consists of 600 shares.

You start making profits once the price of Reliance in the cash market crosses Rs 980 per share (i.e., your strike price of Rs 970 + premium paid of Rs 10).

Now let's take a look at how your investment performs under various scenarios. If the AGM does not result in any spectacular announcements and the share price remains static at Rs 950 or drifts lower to Rs 930 because market players are disappointed, you could allow the Call Option on Reliance to lapse. In this case, your loss would be Rs 10 per share, amounting to a total of Rs 6,000. However, things could have been worse if you had purchased the same shares in the cash market or in the futures segment.
On the other hand, if the company makes an important announcement, it would result in a good amount of buying and the share price may move to Rs 1,000. You would stand to gain Rs 20 per share, i.e., Rs 1,000 less Rs 980 (strike price of Rs 970 + premium of Rs 10), which was your cost per share.

As in the case of the index Call Option, the writer of this Options would stand to gain only when you lose and vice versa, and to the same extent as your gain/loss.