Options – Call and Put Description

Call is right to buy and put is right to sell. Please remember that calls and puts do not oblige you to buy or sell respectively. They merely give you right to exercise your option to buy or sell. Let’s see what calls and puts are.

A call is right to buy an asset at a specified price within a specified period of time. A put is right to sell an asset at a specified price within a specified period of time.

The person who buys the right is called buyers of the option. The person who sells the right is called seller or writer of the option. The buyer has the option to buy or sell as per the type of option but the buyer may choose not to exercise his option and let it lapse. The seller or writer has no such liberty. If the buyer is ready to exercise his or her option, the seller has to honour it.

Example

Let’s take an example to illustrate the concept of call and put. We will discuss call first.

Suppose a trader Karthik buys right to buy stocks of IDBI bank at Rs 145 a share in 3 month. This means Karthik goes long on IDBI bank at strike price of Rs 145 a share at the end of 3^rdmonth. At the end of 3 months, the price of IDBI bank is Rs 142 per share. What will Karthik do? He will not buy as the market price itself is Rs 142 a share. He would not like to pay Rs 145 for something which he can get from open market Rs 142. Karthik has the right not to buy the share.

Suppose at the end of three months, the price of IDBI bank is turns to be Rs 150 per share. Will Karthik exercise his right to buy IDBI bank at Rs 145 a share? The answer is yes. Karthik, or any investor, will love to buy something at Rs 145 which is available in the open market for Rs 150. In this case, the seller is obliged to sell if Karthik chooses to buy IDBI bank stocks.

Let’s take the example of a put option:

Suppose Karthik buys right to sell Aurobindo Pharma at Rs 1200 a share at the end of two months. This means Karthik goes short on Aurobindo Pharma at strike price of Rs 1200 a share at the end of two months. At the end of two months, the price of Aurobindo Pharma is Rs 1250 a share. What will Karthik do? Will Karthik sell something at Rs 1200 a share for which the market price is Rs 1250 a share? The answer is no.

Suppose at the end of two month, the price of Aurobindo Pharma turns out to be Rs 1100 a share. Will Karthik exercise his right? The answer is yes. Karthik will love to sell something at Rs 1200 for which the market price is Rs 1100. He can make neat profit of Rs 100 a share. The seller or writer in this case is obliged to buy Aurobindo Pharma share at Rs 1200 a share if Karthik chooses to sell it.

The Price of Choice

Why would the seller of writer of an option take the risk? Why would he prefer to be on the receiving end of the agreement? Why should buyer have an advantage of deciding whether to buy or sell based on the type of option and stock price?

The answer is premium. Premium is an amount that buyer of an option pays to seller or writer of the option. By paying the premium, the buyer limits his losses but the seller or writer of the option exposes himself to theoretically unlimited losses. The incentive of buyer is limited loss and unlimited gain while the incentive of seller or writer is upfront income.

Let’s summarize the payoff to Buyers and Sellers of options:

The market price has no theoretical limit while premium and exercise price are fixed. Hence we can say the maximum gain on call option for buyer of the option is theoretically unlimited while maximum loss is the premium that the buyer paid. Similarly the theoretical maximum loss for seller is unlimited while the maximum gain is upfront premium paid by the buyer.

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Pankaj Priyadarshi

Pankaj Priyadarshi is an author at Lastbull.com. He has 11 years of international and domestic experience in the areas of Finance, Management, and Business Analysis in the USA and India.He is a co-founder of 'Vertical Grass', a consulting initiative in the area of finance. A Graduate from IIT(Engineering) and ISB(Management).

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