• SEPTEMBER 27, 2004

A share, a call option?

Introduction of the derivatives segment in the Indian capital markets has proved to be a boon as far as investors are concerned. Derivatives provide the much-needed hedging tool to the investors so as to protect themselves from the vagaries of the volatile share prices in the cash market.

However, one form of a derivative contract – the call option – was very much existent in the capital market much before it was formally launched. Surprised? Well, let us first understand what is a call option.

A ‘call option’ gives the buyer a ‘right’ to purchase the underlying shares at a certain future date, at a pre-determined price (also called the strike price). It is to be noted that the buyer has the right and not the obligation to buy the underlying. For example, let us say that Mr. A buys a call option (to purchase) for one contract of Infosys (1 contract = 200 shares) at a strike price of Rs 1,700 to be settled on the last Thursday of September (as per stock market norms) at a premium of Rs 5 per share (Rs 1,000 for the contract)

The above chart explains the trade-offs for a call buyer. The downside is explained to the extent of Rs 5 as far as the current stock price in the cash market is below the strike price of Rs 1,700. However, as soon as the share price in the cash segment moves above the strike price of Rs 1,700, the investor shall witness gains and this amount could be unlimited to the date of expiry.

Now, as on the date of settlement, if the stock price ends up at Rs 1,750, Mr. A would exercise his option and would make a profit of Rs 45 per share (profit = 1,750 minus 1,700 minus 5), or Rs 9,000 per contract. This, however, excludes brokerage and other transaction costs. In other words, Mr. A would make gains once the market price goes above the strike price.

Now let us take the case of a share price. Mr. A would buy the shares of Infosys in expectation of making a capital gain. Now, here is the analogy between buying shares and buying a call option. Let us take Rs 1,700 as the share price. Mr. A, being a long-term investor, would hold on to the shares. Here, the strike price per share would be to the limit of debt held by the company (as creditors have first charge over the assets of the company). Anything above the debt amount would be considered shareholders’ money. At the same time, maturity of the option refers to the debt maturity period. Once the debt burden has been cleared, the assets (which were a collateral to debt) now belong to the shareholders.

To that extent, shares could be compared to call options. While we believe that this article will help open one’s mindset towards learning options and futures, small investors need to take note of the fact that trading in the derivatives segment is an expensive option relative to investing directly or through a mutual fund. Over that, if not understood properly, the derivatives market (that is meant for hedging risks) might prove to be a risky bet for small investors!

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