WHAT IS CALL OPTION ? | CONCEPT & EXAMPLES | CMA US, CFA, ACCA

Summary

In this video, CA Mohit Roora explains the concept of financial derivatives, focusing on options trading. He details how options, particularly call and put options, work as financial tools for managing risks. Using the example of Kisan Company, which manufactures sauces, he illustrates how companies can hedge against price fluctuations of raw materials, like tomatoes, by entering into options contracts. Roora also discusses the roles of the option buyer and seller, the risks involved, and the rewards, making complex financial concepts accessible for students and professionals interested in finance.

Takeaways

• 😀 Options are a type of derivative, meaning their value depends on the underlying asset, such as crude oil or gold prices.
• 😀 A derivative is a financial instrument whose value is tied to the price movements of an underlying asset, and does not have its own standalone value.
• 😀 There are two main types of options: Call options (the right to buy at a specified price) and Put options (the right to sell at a specified price).
• 😀 In options trading, there are two main parties: the option buyer (who holds the right) and the option seller (who has the obligation).
• 😀 A call option gives the buyer the right to purchase an asset at a specified price (strike price) at a future date, while a put option gives the right to sell.
• 😀 Farmers or companies, such as Kisan Company in the example, can use options to hedge against price fluctuations of critical commodities like tomatoes.
• 😀 In the example, Kisan Company could buy a call option to lock in a price for tomatoes at ₹10,000 per ton, protecting themselves against price increases.
• 😀 The buyer of an option pays a premium to the seller, which is a fixed cost. This premium is paid upfront and represents the buyer’s risk exposure.
• 😀 If the market price is lower than the strike price in a call option, the buyer will not execute the option but will purchase the asset at the lower market price.
• 😀 If the market price is higher than the strike price in a call option, the buyer can exercise the option to buy at the lower agreed price, benefiting from the price difference.

Q & A

What is a derivative in financial markets?

A derivative is a financial instrument whose value is derived from an underlying asset. Its value depends entirely on the price movement of that asset, which could be anything like crude oil, gold, or even agricultural products like tomatoes.

What is the difference between a call option and a put option?

A **call option** gives the buyer the right to buy an asset at a predetermined price, while a **put option** gives the buyer the right to sell an asset at a predetermined price. The buyer of a call option profits if the asset price rises, and the buyer of a put option profits if the asset price falls.

How do options work in hedging against price fluctuations?

Options allow companies to lock in prices for future transactions, helping them hedge against potential price increases or decreases. For example, a company may buy a call option to secure a lower price for an asset they need, protecting them from rising prices.

What is the role of the option buyer and option seller?

In an options contract, the **option buyer** has the right, but not the obligation, to execute the contract. The **option seller**, on the other hand, has the obligation to fulfill the contract if the buyer chooses to exercise the option.

What is the concept of an option premium?

An option premium is the price paid by the buyer to the seller for the right to execute the option. This premium is paid upfront, and it represents the maximum risk for the option buyer, while it is the only reward for the option seller.

What would happen if the price of tomatoes rises above the agreed strike price?

If the price of tomatoes rises above the strike price of ₹10,000 per ton, the Kisan Company can execute the call option and buy at the lower strike price, benefiting from the difference. The company would then save money compared to purchasing at the higher market price.

What is the risk for the option buyer and seller in this scenario?

The **option buyer's risk** is limited to the premium paid for the option, but their reward is potentially unlimited if the asset price increases significantly. The **option seller's risk** is unlimited if the price rises beyond the strike price, while their reward is limited to the premium received from the buyer.

What happens if the market price of tomatoes falls below the strike price?

If the market price falls below the strike price, the option buyer (Kisan Company) will likely choose not to execute the option. Instead, they can purchase the tomatoes directly from the market at the lower price, thus losing only the premium paid.

How does the option premium affect the profit or loss for the buyer and seller?

If the market price rises and the buyer exercises the option, their gain is the difference between the market price and the strike price, minus the premium paid. The seller, however, earns the premium but may suffer a loss if the price increases significantly.

Why would a seller agree to sell an option contract when their potential loss is unlimited?

The seller agrees to sell an option because they receive an upfront premium, which is their guaranteed income. However, they must be prepared for the possibility of significant losses if the market price moves unfavorably. Sellers typically take this risk when they believe the market price will not exceed the strike price.