Math of Call Option in stocks
The fact that one can make large asymmetric returns is what makes options attractive instruments to trade. This is one of the reasons why options are popular with the traders
Now that you are familiar with the theoretical concepts of Call option we will get a deeper understanding of the Call option with an example in stock. Let us consider the example of Indian Oil Corporation (IOC) scrip.
The current market price of IOC stock is Rs77.70. The underlying price is simply the spot price of the asset.
As we know when we trade in options there's a lot size. The lot size for IOC is 9750. It makes sense to buy a Call option only when one anticipates an increase in the price of an asset. Assuming our view is bullish we enter into a strike price of 80CE trading at a premium of Rs 1.10 and the expiry falls on last Thursday of the month which is April 27. The strike price is the anchor price at which both the option buyer and option writer enter into an agreement.
Assume there are two traders A and B. A wants to buy this agreement and B wants to sell. Considering the lot size is 9750 the cash flow would be 9750*1.10 = Rs. 10725.
Assume that on April 27, IOC is trading at Rs 85. This means A has the right to buy 9750 shares of IOC at Rs 80. In other words he is getting to buy IOC at Rs 80 when it is trading at Rs 85 in the spot market.
● Trader A pays Rs 7,80,000 ( 9750*80) to B
● Against this B releases 9750 shares at Rs 80 to trader A
● Trader A sells this shares in open market at Rs 85 and receive Rs 8,28,750
● Trader A makes a profit of Rs 48,750
Another way to look at this is that the option buyer is making a profit of Rs 5 per share. As option are cash settled in India the option seller gives him cash equivalent of the profit he makes which means the profit would be 5*9750 = Rs 48,750. Another understanding is if the price of Call option rises from Rs 1.10 to 6.10 which means 5*9750 = Rs 48,750.
The fact that one can make large asymmetric returns is what makes options attractive instruments to trade. This is one of the reasons why options are popular with the traders.
(The author is a homemaker, who dabbles in stock market investments in free time)
