Participation in the Indian stock markets has been growing rapidly in the last few years. Thousands of new investors enter the markets every month with the aim to grow their capital. Many investors believe the cash segment to be the entire stock market. However, contrary to popular belief, the derivatives segment is larger than the cash segment of the market. The derivatives market has evolved considerably in the 20 years since its inception in India. Derivatives products of commodities, stocks, bonds and currencies are traded in India. Options are one of the major derivatives products along with futures, forward contracts and swaps.
What are options?
Options are derivative instruments that provide the right to, but not the obligation, to buy or sell an underlying asset at a specific price and on or before a specific date. Options are binding contracts with clearly defined terms and conditions. Let us understand options and call writing with an example. Rohan is a businessman who plans to sell his textile factory to Rakesh for Rs 10 lakhs. There is a twist in the tale though. The government has restricted the export of the type of textile that Rohan manufactures. However, the government is reconsidering the rule and the restrictions may be lifted. If the government allows the export of the textile, the market value of the factory will increase to Rs 15 lakhs. If the government continues with the export restriction, the value will collapse to Rs 8 lakhs as there is an oversupply of the textile in the domestic market.
- Considering the situation, Rakesh offers an interesting deal to Rohan. Rakesh pays an amount of Rs 1 lakh to Rohan as non-refundable agreement fee.
- Against the fee, Rohan promises to sell the factory after six months to Rakesh for Rs 10 lakh. The selling price is locked with the agreement.
- Since Rakesh has paid an upfront fee, after six months if Rakesh wishes to buy the factory, Rohan cannot rescind the agreement. If Rakesh cancels the deal, Rohan will get to keep the upfront fee. There could be three scenarios after six months.
The government removes the restriction and the market price of the factory jumps to Rs 15 lakhs. In scenario 1, Rakesh will get the factory at the agreed price of Rs 10 lakh. His total investment is Rs 11 lakh and the profit is Rs 4 lakh.
The government doesn’t remove the restriction and extends it further. The price falls to Rs 8 lakh. In scenario 2, Rakesh will most probably refuse to buy the factory. He will lose the Rs 1 lakh paid for the agreement.
There is no decision on the restriction and the market price remains at Rs 10 lakh. Rakesh will let go of the factory in such a scenario as the total investments including the upfront fee will be Rs 11 lakh, while the market price is Rs 10 lakh.
What is call writing in the stock market?
If the same example is replicated in the stock markets, the factory will be the underlying asset. The agreement is the derivative. The price (Rs 10 lakh) is the stroke price and the day after six months is the expiration date. Call writing means to formulate a contract to sell or buy an asset at a specified price on or before a specific date in the future. The call writer is under an obligation and can be forced to sell or buy the asset the strike price on the expiration date. The person writing call options receives a premium to enter into the binding contract. Call options are generally written in lots of multiple shares. The premium for call writing depends on a variety of factors like the current share price, volatility and the expiration date.
Benefits of call writing
The fortunes of the call writer and the option buyer move in the exact opposite direction. If the option buyer earns a profit, the call writer will suffer a loss and vice versa. The call writing strategy that makes it relatively beneficial for the call writer is the premium amount. Since the value of the underlying asset declines with time, the liability and risk of the call writer decreases.
Just like other financial products, call options too have certain risks associated with it. Statistically, call writers have more chances of gaining. Call writing can generate positive returns if the price of the underlying asset remains below or even at par with the stroke price. However, if the price rises over the strike price, the call writer may suffer loss.