Stock Options –A Conceptual Note

A Note By: Sameer Kulkarni, Associate Professor, HOD Chanakya, Mumbai

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There are two derivative instruments which every investor must know of - Futures and
Options. In the following note two different types of Options - Put option and Call
Option are explained, with an example.
1. Buying a Call Option.
2. Selling a Call Option (also sometimes called as writing a Call Option).
3. Buying a Put Option.
4. Selling a Put Option (also sometimes called as writing a Put Option).
Whether it is stock options or commodity options, the underlying concept is the same.
Simple Call Option example - How call option works?
Suppose you are interested in buying 100 shares of a company. For the sake of this
example let us say that the company is Coca Cola and the current price of its stock is
Rs.50. However instead of just buying the shares from the market what you do is the
following: You contact your friend Kiran and tell him "Hey Kiran, I am thinking of
buying 100 shares of Coca Cola from you at the price of Rs.52. However I want to
decide whether to actually buy it or not at the end of this month. Would that be OK?"
(Of course what you have in mind is the following).
1. If the stock price rises above Rs.52, then you will buy the shares from Kiran at
Rs.52 in which case you will gain by simply buying from Kiran at Rs.52 and
selling it in the market at the price which is above Rs.52. Kiran will be at a loss
in this situation.
2. If the stock price remains below Rs.52 then you simply won’t buy the shares
from him. After all you are asking Kiran is the 'option' to buy those shares from
him - you are not making any commitment.
In order to make the above deal 'fair' from the viewpoint of Kiran you agree to pay
Kiran Rs.2 per share, i.e. Rs.200 in total. This is the (risk) premium or the money you
are paying Kiran for the risk he is willing to take - risk of being at a loss if the price
rises above Rs.52. Kiran will keep this money irrespective of whether you exercise your
option of going ahead with the deal or not. The price of Rs.52, at which you would like
to buy (or rather would like to have the option to buy) the shares is called the strike
price of this deal. Deals of this type have a name- they are called a Call Option. Kiran
is selling (or writing) the call option to you for a price of Rs.2 per share. You are
buying the call option. Kiran, the seller of the call option has the obligation to sell
his shares even if the price rises above Rs.52 in which case you would definitely buy it
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 Stock Options –A Conceptual Note

from him. You on the other hand are the buyer of the call option and have no
obligation- you simply have the option to buy the shares.

Simple Put Option Example - How put option works?

Let us consider a situation where now Kiran wants the option to sell you his 100
shares of Coca Cola at Rs.48. He agrees to pay you Rs.2 per share in order to be able
to have the 'option' to sell you his 100 shares at the end of the month. Of course what
he has in mind is that he will sell them to you if the price falls below Rs.48, in which
case you will be at a loss by buying the shares from him at a price above the market
price and he will be relatively better off rather than selling the shares in the market.
The Rs.2 he is willing to pay you is all yours to keep irrespective of whether Kiran
exercises the option or not. It is the risk premium. In this case John is buying a Put
Option from you. You are writing or selling a Put Option to John. Rs.48 is the strike
price of the Put Option. In this case, you the seller or writer of the Put Option has the
obligation to buy the shares at the strike price. Kiran, the buyer of the Put Option has
the option to sell the shares to you. He has no obligation.

Difference between above option examples and 'real life options'

The above examples illustrate the basic ideas underlying, writing a call, buying a Call,
writing a Put and selling a Put. In real life you sell (or write) and buy call & put options
directly on the stock exchange instead of 'informally dealing' with your friend. Here are
some key points to remember about real life options trading.
1. An option trading is directly or automatically carried through at the stock
exchange, you do not deal with any person 'personally'. The stock exchange
acts as a 'guaranteer' to make sure the deal goes through.
2. Each Options contract for a particular stock has a specified LOT SIZE, decided
by the stock exchange.
3. The writers or sellers of Call and the Put option are the ones who are taking the
risk and hence have to pay 'margin' amount to the stock exchange as a form of
guarantee. This is just like the margin money you pay while buying or selling a
futures contract and as explained in the note on futures trading. The buyers of
Call and Put options on the other hand are not taking any risk. They do not pay
any margin. They simply pay the Options premium.