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C. Raja Rajeshwari

STARTING this week, we will be coming out with a new fortnightly column 'Do the Derivatives', to focus on learning about the world of opportunity in derivatives.

A derivative is a security whose value is derived from an underlying security. This week's focus will be on what is an option and what is a call option?

An option contract leaves you with much flexibility in the way it is structured: the following are key facets:

* An option is written on an underlying asset. The latter may be a stock, interest rate, forex rate or even esoteric stuff like the weather.

* It gives you the right to buy the underlying asset later at the specified time.

* The flexibility is that you need not necessarily buy the asset at the later date or during the run-up to that date.

* The price at which the asset can be purchased later is specified when you enter into the option contract.

* * As a contract, it is a binding one with specified terms and properties, just like a stock or bond.

Let's elucidate with an example. X wants to purchase a house from Y. Unfortunately; X does not have the cash to buy it for another three months. X is in a dilemma because by the time he arranges for the money the value of the house may be higher or it might be sold out. Hence, to overcome this, X pays Y a token advance to purchase the house after three months.

This gives X the right to purchase the house at the specified amount from Y on or before the end of three months. In case, X fails to purchase the house, the opportunity loss for Y by waiting for X is made good by the token money paid at the time of deal. At the end of three months or before the end of the contract, either X purchases the house or he does not avail his option as he has found a cheaper house.

Option terms: Here the option, which X has, is a call option x the right to buy the underlying asset.

* A call option is one, which gives the holder the right to 'buy' an asset at a certain price within a specific period.

* If the underlying asset for the call option is a stock then it is similar to having a long position on a stock. Long position is equivalent to owning the stock.

* The token money so paid in the above example is the premium to purchase such an option.

* The specified price to purchase the stock is called the strike price.

* The person who buys the call option is called a 'call holder' and is said to have long positions.

* The person who sells the call options is called a 'call writer' and is said to have a short position.

* The call holder has the right to call on the call writer to take delivery of the stock and

* The call writer has the obligation to deliver the stock at the specified price.

An Example: here is how a call option on equity works. Suppose, Satyam Computers is selling at Rs 183.15 and X purchases an April call option with strike price at Rs 170 paying a premium of Rs 16. The option will be exercised on the expiry date if the price of Satyam's market price on that date is more than 170. In case the price of Satyam is less than Rs 170, it makes no sense to exercise the option and purchase that stock when it can be purchased at a lower price in the spot market.

* The gain for a call holder on exercising the option is the difference between the exercise price and the strike price and the option premium paid.

* Call buyer's Gain = Market price x (strike price + premium)

In the above example if the buyer exercises the call when Satyam's price is Rs 200 then the gain is 200-(170+16), which is Rs 14.

* If it is not exercised then the loss will be just the premium so paid. The profit/loss payoff is the opposite for a call writer.

Call buyers have a view that the stock will increase substantially before the option expires x bullish view, whereas the call writer has the opposite view.

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