A Note On Investment Strategies Involving Options

INVESTMENT STRATEGIES INVOLVING OPTIONS Contd..

Call Options

Let us understand the basics of call option with the help of the following example:

Example:

A buys a European call option on a share of Philips at a premium of Rs. 3 per share on October 01, 2002. The strike price is Rs.65 and the contract matures on December 31, 2002. The payoff table (Refer Table 2) shows the payoffs for the investor on the basis of the different spot prices at any given time. It is also clear from the graph that in the worst possible case, A would only lose a maximum of Rs.3 per share, which has been paid as an option premium. However, the upside to it is that he has an unlimited profit opportunity.

On the contrary, the seller of the call option has a payoff chart, completely reverse to that of the call options buyer. In this case, the maximum profit a seller gains will be Rs.3 per share, while the losses suffered would be unlimited.

Table 2: Payoff from Buying Call Option (Rs.)

S	Xt	C	Payoff	Net Profit
62	65	3	0	-3
63	65	3	0	-3
64	65	3	0	-3
65	65	3	0	-3
66	65	3	1	-2
67	65	3	2	-1
68	65	3	3	0
69	65	3	4	1
70	65	3	5	2
71	65	3	6	3

A European call option gives the following payoff to the investor: max (S – Xt, 0).
The writer of a call option gets a payoff: min (Xt – S, 0).

Where,
S – Stock Price at time‘t'
Xt – Exercise Price at time‘t'
C – European Call Option Premium
Payoff – Max (S - Xt, 0)
Net Profit – Payoff minus 'C'

In the above example, we can infer that the buyer of the call option would exercise his option only when he makes profit. If the spot price is lower than the strike price, it would be profitable for A to buy the share in the open market and forgo the premium paid.

Investors buy call options when they feel that the stock market will rise significantly in the short term. However, if a shareholder feels that his/her shares are not expected to rise in the short-term, he can earn a premium by selling a call option on that share. The payoff diagram will be completely opposite to that of an investor when he/she is long on call.