A STORY TO BEGIN WITH

It's the evening of March 17th, 2020. The world is gripped by the unfolding pandemic, and financial markets are in freefall. Amidst this chaos, a young trader named Aryan sits in his Mumbai apartment, staring at his laptop screen. The Nifty has plummeted to 8,967. Most investors are scrambling to cut their losses, but Aryan sees an opportunity.

Aryan has been studying options trading for months. Fascinated by their potential, he decides to make a bold move. With his savings of five lakh rupees, he buys a series of put options, betting that the market will drop further. His friends call him crazy, but Aryan is confident.

The next day, March 18th, the market opens to a grim reality. The Nifty plunges further, hitting circuit breakers within minutes. Panic spreads, but Aryan's screen glows green. His put options have exploded in value. By the time the dust settles, Aryan's position is worth fifty lakh rupees. He has made a 1000% return in less than 24 hours.

This story isn't just about luck. It's about understanding the power of options. Aryan used options to amplify his gains during market chaos. Options trading is not just about predicting market moves; it's about strategic positioning and managing risk.

In this module, we will explore the world of options trading. We will explain call and put options in simple terms but first, let's explore the fascinating history of options.

HISTORY OF OPTIONS

Did you know that options trading has roots as ancient as Greece? It’s true! But it's in the 20th century that things really took off, especially with the creation of the Chicago Board Options Exchange (CBOE) in 1973. This was a game-changer, transforming the financial world by introducing standardised contracts, making options trading a regulated and mainstream practice.

Now, what about India? The journey here has been equally exciting, marked by several key milestones. On June 4, 2001, the National Stock Exchange (NSE) launched index options. Not long after, on July 2, 2001, NSE expanded trading opportunities by introducing stock options on individual securities. By 2016, weekly options contracts were introduced, allowing traders to capitalise on short-term market movements.

Then came the COVID-19 pandemic, turning everything upside down. Amidst the chaos, something unexpected happened—the options trading market in India boomed. With everyone going digital, trading volumes and participation skyrocketed. Retail investors flooded the market, making India a rising star in the world of options trading. But, despite the progress, India's liquidity in stock options still lags behind international markets.

This unexpected boom in trading might leave you wondering, what exactly are options? They can seem like complex financial instruments with a lot of jargon. But don't worry; we're here to break it down together. We'll start with the basics: Call options. And what better way to understand them than through a story?

OPTIONS EXPLAINED WITH THE HELP OF STORIES

Karun and Ankit had been best friends since their school days, often discussing new business ideas and investment opportunities. One warm afternoon, while sipping chai at their favourite tea stall in Bangalore, Karun brought up a new topic. He was eyeing 1 acre of land that Ankit owned, priced at Rs. 40,00,000. Karun had heard rumours about a new metro project that could potentially increase the land's value. But he was worried; if the project didn’t come to our city, he’d be stuck with a piece of land that might not grow much in value.

“Ankit, I’m really interested in buying your land, but I’m not sure if it’s the right time,” Karun began, stirring his tea absentmindedly.

Ankit, always the Problem solver, replied, “I understand your hesitation, Karun. It’s a big investment. But what if we found a way to reduce your risk?”

Karun’s Dilemma

Karun was in a tricky spot. He wanted to buy the land because of the potential metro project, but he didn’t want to risk losing a lot of money if the project didn't happen. If he bought the land and the project didn’t come through, he would have invested Rs. 40,00,000 in something that might not gain any value. But if the project did happen, he could make a huge profit. Karun needed a way to secure the land without committing to buy it outright.

Ankit’s Proposal

Seeing Karun’s uncertainty, Ankit proposed a clever deal. “How about this,” Ankit said, leaning forward, “You pay me Rs. 5,00,000 now. In return, I agree to sell you the land for Rs. 40,00,000 in six months. If you decide not to buy, I keep the Rs. 5,00,000.”

Karun was fascinated. This Rs. 5,00,000 would be like a fee to buy the land later at the agreed price. This way, he wouldn’t have to buy the land if the metro project didn't happen. He'd only lose the Rs. 5,00,000, which was much less risky than losing Rs. 40,00,000.

“Okay, Ankit. Let’s do this,” Karun agreed, feeling a mix of excitement and relief. They drew up a simple contract, and Karun handed over the Rs. 5,00,000.

This arrangement was similar to buying a call option in the stock market. A call option gives you the right not the obligation to buy a stock at a set price before a certain date. You pay a fee for this agreement, known as the premium ( in this case it was 5 lakhs).If the stock price goes up, you can buy it at the lower set price and make a profit. If it doesn’t, you only lose the premium.

The Waiting period

Over the next six months, Karun and Ankit continued with their lives, but the fate of the metro project was always at the back of Karun’s mind. He often found himself driving past the land, imagining what it could be worth if the project went through. Ankit, on the other hand, felt comfortable knowing that he had already pocketed Rs. 5,00,000, regardless of what Karun decided.

Scenarios and Outcomes

Here’s what could happen after six months:

Scenario 1: Price Rises to Rs. 80,00,000

The metro project is announced, and the land's value jumps to Rs. 80,00,000. Karun’s decision to buy the option pays off handsomely. He exercises his right to purchase the land for Rs. 40,00,000. Including the Rs. 5,00,000 premium, his total cost is Rs. 45,00,000.

He can then sell the land at the new market price of Rs. 80,00,000, making a profit of Rs. 35,00,000. His Rs. 5,00,000 initial investment has yielded a substantial return. Ankit, despite the land's higher value, must sell at the agreed price due to the agreement.

Scenario 2: Price Falls to Rs. 20,00,000

Suppose the metro project turned out to be just a rumour. The market reacted negatively, and the land's value fell down to Rs. 20,00,000. In this case, Karun would not exercise his option to buy the land. It wouldn’t make sense to pay Rs. 45,00,000 (Rs. 40,00,000 for the land plus Rs. 5,00,000 premium) for something now worth Rs. 20,00,000. Karun would forfeit the Rs. 5,00,000, which Ankit would pocket, but he avoided a larger financial loss.

Scenario 3: Price Stays at Rs. 40,00,000

If the land’s value remains Rs. 40,00,000, Karun won't exercise his option. Buying the land would cost him Rs. 45,00,000 in total, more than its market value which makes no sense. Karun walks away, losing the Rs. 5,00,000 premium, but he avoids paying extra for the land.

Frequently Asked Questions (FAQs)

Why did Karun take this bet knowing he could lose Rs. 5,00,000 if the land price doesn't increase?

Karun took the bet because he knew his maximum loss upfront, which was Rs. 5,00,000. This way, there were no surprises. If the land price increased, his profits could be substantial and it not he would lose only 5,00,000 instead of 40,00,000 making the risk worth it.

Under what conditions does Karun’s position make sense?

Karun’s position makes sense only  if the land price increases. He benefits from buying the land at a lower price and selling it at the market price. Rest two scenarios are not profitable from Karun’s point of view.

When does Ankit’s position make sense?

Ankit benefits if the land price stays the same or decreases. He keeps the Rs. 5,00,000 premium without having to sell the land at a lower price.

Why did Ankit take this risk?

Ankit took the risk because two out of three possible outcomes benefit him. If the land price doesn’t increase, he keeps the premium. Statistically, he has a higher chance (⅔) of benefiting.Hence convincing him to get into this deal.

Deeper understanding of call options:-

 Here’s a deeper look into the elements and implications of their agreement:

-Karun's Right and Ankit's Obligation : By paying the premium, Karun gained the right to buy the land at the predetermined price of Rs. 40,00,000 within the six-month period. This means that only Karun can decide whether to go through with the purchase. Conversely, Ankit is obligated to sell the land to Karun at that price if Karun chooses to exercise his right.

Purpose of the Premium: The Rs. 5,00,000 premium acts as compensation to Ankit for providing Karun with this right. It ensures that Ankit is compensated for the commitment, regardless of whether Karun eventually buys the land.

Underlying Asset and Derivative Nature: The land in question serves as the underlying asset in this scenario. The agreement they entered into is an option, which is a type of derivative because its value is derived from the value of the underlying asset, in this case, the land.

Fixed Variables: Several key variables are fixed in this options agreement, namely the area of the land ( here 1 acre), the agreed price of Rs. 40,00,000, and the six-month period during which Karun can exercise his right to purchase. These fixed elements provide clarity and structure to the agreement, leaving no room for ambiguity.

Roles in the Agreement: Within this options framework, Karun is known as the 'option buyer' or 'agreement buyer', because he has the right to buy. On the other hand, Ankit is the 'option seller' or 'agreement writer', since he must fulfil the obligation to sell the land if Karun decides to buy.

Non-Obligatory Nature for the Buyer: A crucial aspect of this agreement is that Karun, as the option buyer, holds the right but not the obligation to purchase the land. This means that if the land's market value does not increase to a level that benefits him, Karun can choose not to proceed with the purchase. His only loss in this case would be the Rs. 5,00,000 premium, mitigating the risk of a larger financial loss.

Obligatory Nature for the Seller: In contrast, Ankit, as the option seller, is bound by the agreement to sell the land to Karun at Rs. 40,00,000 if Karun decides to exercise his option. This obligation is the trade-off for receiving the premium upfront.

Strategic Risk Management: For Karun, this agreement serves as a strategic risk management tool. By paying the premium, he secures the potential to benefit from an increase in the land's value while capping his downside risk to the premium amount.

Economic Implications: This kind of options agreement is a powerful financial tool. It allows buyers like Karun to speculate on potential future increases in asset value with limited risk. Meanwhile, sellers like Ankit benefit from the premium and the potential to sell an asset at a predetermined price, providing a hedge against future price declines.

This detailed breakdown highlights how options agreements can manage risk and capitalize on opportunities in various scenarios, like Karun and Ankit's example with call options in the stock market.

Finalising - call options: A call option lets you buy shares at a set price within a specific period, for a premium. If the share price rises, you profit by buying at the lower price and selling at the market price; if not, you only lose the premium.

We hope that you have now developed a solid understanding of call options. In the subsequent chapter, we will explore the various terminologies used in options trading in greater detail.