Simplifying Call Option – By Prof. Simply Simple TM

I hope the last lesson on „Options‟ helped you in getting

to understand the concept.

In continuation of that, we also discussed the „Put‟

option for your clarity on the subject.

Having explained the „Put‟ option, quite naturally, you‟ll

want to know about the „Call‟ option.

Let me try & explain it in the next few slides…

Let‟s look at the same example

for the farmer & bread

manufacturer 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 an

input 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 a

Futures 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 manufacturer

cannot 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 has

clarified the difference between

the „Put‟ and „Call‟ option.

Basically in the „Put‟ option

the choice of honoring the

contract 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.

To Sum Up

• In a ‘Futures Contract’ both parties are

obliged to honor the contract.

• In an ‘Options Contract’ one of the parties is given the privilege to exit the option on settlement date and the party has to oblige.

• In a ‘Put’ option this privilege is given to the seller (in our example - the farmer)

• In a ‘Call’ option this privilege is given to the buyer (in our example - the bread manufacturer)

Copyright © 2009

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

professor@tataamc.com