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Understanding how a typicalOption Deal is done in the market

By Prof. Simply SimpleTM

In one of our recent lessons, wehad explained how in a marketcomprising of several buyers

and sellers, one need not know

who thecounter-party is.

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We had also covered a lesson onOptionsin order to get an

understanding of theconcept.

I will now explain to you howan Option Dealispractically

donein themarket place.

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In thestock market there areseveralparticipants who are both

buyers and sellers

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Astock market is a platformwhere thisis free flow of

information

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Thisisso that thecurrent stock priceis

known to every participant (buyers andsellers)Any participant trying to extracta higher price will not be able to do sobecause of the free flow of information

which prevents any sort of pricearbitrage.

Thisis what wecallPrice Discovery.

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Now letssay thereis a stock option on stock A, which

iscurrently quoting at Rs.100. And letssay the optionexpires after 5 days

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Now letssay there are two participants Ram &

Samin thismarket.

Ramis of theview that thestock prices would go

upin near future and hecould makeprofit by

buying stock A at Rs. 120 today. But Ram does

not want to take downside risk to an unmeasured

extent (i.e. in case theprice falls below Rs 120).

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Hence hechooses to buy a call option which protects

him against any downside risk. For getting thisservice

he would have to pay a premium to theseller of the

option. Theseller of the option,Sam, on the other hand

has a view that theprice of thestock will fall,in which

case, he knows that the buyer willNOT exercise hisoption so that hecan earn thepremium of

letssay Rs 2.

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To understand this better lets assume that Ram

has bought a call option at thestrikeprice of Rs.

120 (i.e. theprice at which he gets a right to buy

thestock Ain future from theseller of thecall

option).

Now,look at how thepricesmovein these 5 days

and what implicationsit has for Ram & Sam

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It isimportant to understand that this tradestarts with a debit

balance of Rs 2 ( thepremium)in the buyers (Ram) account

while thesellers account would show a credit balance of the

same amount ( Rs 2 Premium amount). Further, it is

imperative to know that Rs. 2 is the maximum debit and credit

which can occur in Rams and Sams account respectively.

Day 1

Sam

Seller

Debit Credit

Premium

Rs. 2

Ram

Seller

Debit

Premium

Rs 2

Credit

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Rams buying price of the Options on day One 120

Closing Price on day One 122

His notionalprofit at theend of day One Rs. 2

But, unlike futures, Rams account will not becredited by this

profit till hesettles or squares off hiscontract. However,

Sams account would be debited by Rs 2 since heis obliged to

honor thecontract.

Day 1

Sam

Seller

Debit Credit

Premium

Rs. 2

Day 1 Rs 2

Ram

Buyer

Debit

Premium

Rs 2

Credit

Day 1

(notional

profit Rs.

2)

NIL NIL

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Closing Price on day two 125

Rams gross notionalprofit now is Rs. 5 and Samsloss

compared to thepreviousclosing priceis Rs. 3. So,in theend,

Sams account gets debited by Rs 3 asshown in the tables

below.

Day 2

Sam

Seller

Debit Credit

Premium

Rs. 2

Day 1 Rs 2

Day 2 Rs 3

RamBuyer

DebitPremium

Rs 2

Credit

Day 1 Nil Nil

Day 2(notional

profit

Rs. 5)

Nil Nil

Ramcan cash out his notionalprofit today by assigning hiscall option to Sam. Samcannot exit thecontract; however; hecan pass on hisprobable future obligation to some other participants by honoring

thelosses till date.

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Closing Price on day Three 124

Rams notionalprofit comes down to Rs. 4 and Sams account

would get credited by Rs 1.

Day 3

Ram

Buyer

Debit

PremiumRs 2

Credit

Day 1 Nil Nil

Day 2 Nil Nil

Day 3(notional

profit

Rs. 4)

Nil Nil

Sam

Seller

Debit Credit

Premium

Rs. 1

Day 1 Rs 2

Day 2 Rs. 3

Day 3 Rs 1

Ramcan cash out his notionalprofit today by assigning hiscall option to Sam. Samcannot exit thecontract; however, hecan pass on hisprobable future obligation to some other participants by honoring

thelosses till date.

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Closing Price on day Four 123

Rams notionalprofit willcome down to Rs. 3 and Samsaccount would get credited by Rs 1.

Day 4

Ram

Buyer

Debit

Premium

Rs 2

Credit

Day 1 Nil Nil

Day 2 Nil Nil

Day 3 Nil Nil

Day 4

(notional

profit Rs.

3)

Nil Nil

Sam

Seller

Debit Credit

Premium

Rs 2

Day 1 Rs 2

Day 2 Rs 3

Day 3 Rs 1

Day 4 Rs 1

Ramcan cash out his notionalprofit today by assigning hiscall option to Sam. Samcannot exit thecontract; however; hecan pass on hisprobable future obligation to some other participants by honoring

thelosses till date.

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Closing Price on day Five 127

Rams notionalprofit would increase to Rs.7. So at

theend of day 5 (settlement day), Rams account

with his broker would get credited by Rs 7 while

Sams account would get debited by Rs. 4.

Day 5 Settlement Date

Ram

Buyer

Debit

Premium

Rs 2

Credit

Day 1 Nil Nil

Day 2Nil Nil

Day 3 Nil Nil

Day 4 Nil Nil

Day 5 Rs 7

Sam

Seller

Debit Credit

Premium

Rs 2

Day 1 Rs 2

Day 2Rs

3

Day 3 Rs 1

Day 4 Rs 1

Day 5 Rs 4

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Thus theeffect of the 5 daysleading to the

settlement would look like this

Day 5 Settlement Date

Ram

Buyer

Debit

Premium

Rs 2

Credit

Day 1Nil Nil

Day 2 Nil Nil

Day 3 Nil Nil

Day 4 Nil Nil

Day 5 Nil Rs 7

Total Rs 2 Rs 7

Net gain Rs. 5

Sam

Seller

Debit Credit

Premium

Rs 2

Day 1Rs

2

Day 2 Rs 3

Day 3 Rs 1

Day 4 Rs 1

Day 5 Rs 4

Total Rs 9 Rs 4

Net Loss Rs 5

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In thiscase, the Call Option buyer has a net gain of Rs 5

while the Call Option seller has a net loss of Rs 5

Day 5 Settlement Date

Ram

Buyer

Debit

Premium

Rs 2

Credit

Day 1Nil Nil

Day 2 Nil Nil

Day 3 Nil Nil

Day 4 Nil Nil

Day 5 Nil Rs 7

Total Rs 2 Rs 7

Net gain Rs. 5

Sam

Seller

Debit Credit

Premium

Rs 2

Day 1Rs

2

Day 2 Rs 3

Day 3 Rs 1

Day 4 Rs 1

Day 5 Rs 4

Total Rs 9 Rs 4

Net Loss Rs 5

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But what would have happened if on thelast day instead

of theprice rising by Rs 4,it had fallen by Rs 7 to Rs.

116?

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Asseen in the tableif theprices had fallen on the 5th day, the Call Option

buyers account ( RamsAccount) would not be debited by any amount. But

his notionalprofits will wipe out and he will not lose any thing beyond Rs.

2 paid towards buying thecall option. In thecase of Sam, apart frominitial

premium, his account will becredited to themaximumextent of his

previous net debits. So,if price of thestock comes down to Rs. 116,sellers

account (Sams account) would get credited to themaximum of Rs. 3.

Ram

Buyer

Debit

Rs. 2

Credit

Day 1 Nil Nil

Day 2 Nil Nil

Day 3 Nil Nil

Day 4 Nil Nil

Day 5 Nil Nil

Sam

Seller

Debit Credit

Premium

Rs 2

Day 1 Rs 2

Day 2 Rs 3

Day 3 Rs 1

Day 4 Rs 1

Day 5 Rs 3

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The final reconciliation in thiscase would be

somewhat like this

Ram

Buyer

Debit

Premium

Rs 2

Credit

Day 1 Nil Nil

Day 2 Nil Nil

Day 3 Nil Nil

Day 4 Nil Nil

Day 5 Nil Nil

Total Rs 2 Rs 0

Net Loss Rs 2

Sam

Seller

Debit Credit

Premium

Rs 2

Day 1 Rs 2

Day 2 Rs 3

Day 3 Rs 1

Day 4 Rs 1

Day 5 Rs 3

Total Rs 5 Rs 7

Net Gain Rs 2

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Thus, wesee that Ram has unlimited upside gain but

limited downsideliability whileSam on the other

hand has unlimited downsideliability but a limited

upside gain to the tune of thepremium amount only.

Thus the Call Option buyer has limited risk while

the Call Option seller takes a much larger risk!

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Phew! That was quite a tough one. I hope you have got

some understanding of thisesotericconcept which

dodges the brightest brainsmany a times.

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Please do let me know if I havemanaged to clear

thisconcept for you. Your feedback isveryimportant to me asit helpsmeplan my future

lessons.

Ple

ase

give

your fee

dback atprofessor@tataamc.com

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Theviewsexpressed in theselessons are for informationpurposes only and do not construe to be of any investment,legal or taxation advice. They are not indicative of future

market trends, nor is Tata Asset Management Ltd. attemptingto predict thesame. Reprinting any part of thispresentationwill be at your own risk and Tata Asset Management Ltd. will

not beliable for theconsequences of any such action.

Disclaimer