Call option:How to Calculate Payoffs

From the previous chapters, you got to know what options are and what the process flow of a call option is. But how do you employ call options to earn profits and how to calculate the payoffs that you receive by trading in them? These are a couple of questions that we will be addressing in this chapter. But, before we get to the main crux of the chapter, let’s take a brief look at how to read an options contract.

Basics of an options contract

To understand the basics of an options contract, we’ll take up a contract of Asian Paints Limited, a paint manufacturing company. If you log into your trading portal and search for call option contracts of Asian Paints, you’re likely to see something like this.

Let’s break this contract down into four parts to try and understand what it means. 

• ASIANPAINT: This denotes the symbol of Asian Paints Limited as listed on the NSE.
• JUL: This denotes the month of expiry of the options contract. In this case, the options contract expires in the month of July. We’ll discuss contract expiries shortly in the next segment of this chapter.
• 1600: This value denotes the strike price of the options contract. It is the ‘predetermined’ price in a contract and is the price at which you agree to buy or sell the stock or index on the date of expiry.  
• CE: The tag ‘CE’ denotes that the contract is a call option.

Contract expiry

Unlike regular shares, options contracts have an expiry date. Typically options contracts expire on the last Thursday of every month. In case the last Thursday of the month is a holiday, the contract will expire on the previous trading day. 

So, for instance, take the case of a contract expiring in July, 2020. What would be the date of contract expiry? Yes, it would expire on the 30th of July, 2020, which is the last Thursday of the month.  

With respect to options contracts of a stock or an index, at any point in time, there are always contracts with three different expiries listed on the stock exchange. For instance, if you were to search for the options contracts of Asian Paints Limited on your trading portal in the month of July, you’ll likely find the following entries.    

• ASIANPAINT JUL 1600 CE
• ASIANPAINT AUG 1600 CE
• ASIANPAINT SEP 1600 CE

The first contract expires in the month of July, which is also known as the ‘near month.’ The second contract expires in the month of August, which is termed as the ‘next month.’ The third and final contract expires in the month of September, which is termed as the ‘far month.’

Another interesting point to note is that the near month, next month, and the far month keep changing with every expiry. So, when the July contracts have expired, the near month then becomes August. September and October then become the next month and the far month respectively. Given this, here’s what you’ll find listed in August.

• ASIANPAINT AUG 1600 CE
• ASIANPAINT SEP 1600 CE
• ASIANPAINT OCT 1600 CE

Calculation of call option payout

Now that the basics of options contracts are done and dusted, it is time to take an in-depth look into how to calculate the payoffs for a call option and see how much you can earn by just trading options in the stock exchange.

Since we’ve been talking about Asian Paints Limited, we’ll take up a hypothetical call option contract of the same company and get to know how to calculate the call option payout. First off, let’s get some preliminary details out of the way. 

• Assume that currently Asian Paints Limited is trading at Rs. 1,600 in the spot (cash) market. 
• We have an options buyer, Ranjeet, who expects that the share price of Asian Paints would go further up by the date of expiry, which in this case is July 30, 2020. 
• So, Ranjeet  wants to have the option to buy the shares at a lower price in the future. 
• We also have an options seller, Latika, who expects that the share price would fall by the date of expiry. 
• So, Latika wants to sell the shares of Asian Paints at a higher price in the future. 
• Therefore, they both enter into the ASIANPAINT JUL 1600 CE contract on July 1, 2020. 
• Here, the buyer of the call option is Ranjeet and the seller of the call option is Latika.
• According to the call option contract, Latika gives Ranjeet the right to buy 10 shares of Asian Paints Limited on July 30, 2020 for Rs. 1,600 per share.    
• In return for giving Ranjeet the right to buy, Latika charges a premium of Rs. 20 per share from Ranjeet, bringing the total premium up to Rs. 200 (Rs. 20 x 10 shares)

Now that we’re clear with the specifics of the contract, let’s take a look at four different scenarios and the respective call option payoff calculations.   

Scenario 1: On the expiry date, say the shares of Asian Paints Limited are trading at Rs. 2,000 each.

Ranjeet’s point of view 

• Since the price of the share has increased, just as per Ranjeet’s expectations, he chooses to exercise his call option. 
• In other words, he exercises his right to buy 10 shares of Asian Paints at Rs. 1,600 each instead of at the current market price, which is Rs. 2,000 per share. 
• So, from this entire call option trade, Ranjeet makes a notional profit of Rs. 4,000 [(Rs. 2,000 - Rs. 1,600) x 10 shares]. 
• The total net profit that Ranjeet gets to enjoy if he sells the shares in the cash market after taking delivery from Latika is Rs. 3,800 (Rs. 4,000 - Rs. 200). Here, Rs. 200 is the premium Ranjeet paid Latika for buying the call option contract from her.

Latika’s point of view 

• Since Ranjeet chose to exercise his right, Latika is obligated to sell him 10 shares of Asian Paints Limited at Rs. 1,600 per share even though the market price is Rs. 2,000 each. 
• So, from this entire call option trade, Latika makes a notional loss of Rs. 4,000 [(Rs. 2,000 - Rs. 1,600) x 10 shares].
• The total net loss that Latika has to bear when she sells the shares to Ranjeet at Rs. 1,600 instead of at the current market price is Rs. 3,800 (Rs. 4,000 - Rs. 200). Here, Rs. 200 is the premium received from Ranjeet for selling him the call option contract. 

Let’s tabulate the cash flow of Ranjeet and Latika as a consequence of this call option trade. 

Scenario 2: On the expiry date, say the shares of Asian Paints Limited are trading at Rs. 1,000 each.

Ranjeet’s point of view 

• Since the price of the share has decreased and gone contrary to Ranjeet’s expectations, he chooses to not exercise his call option. 
• In other words, Ranjeet doesn’t exercise his right to buy 10 shares of Asian Paints at Rs. 1,600 from Latika, because he can get it directly from the equity market at the current market price of Rs. 1,000.
• So, from this entire call option contract, Ranjeet’s total loss is limited to only the premium he paid at the time of entering into the contract with Latika, which is Rs. 200. 

Latika’s point of view 

• Since Ranjeet chose to not exercise his right, Latika cannot force him to buy the shares of Asian Paints Limited from her at Rs. 1,600. 
• So, on the expiry date, no trade occurs. 
• However, Latika gets to keep the premium that Ranjeet paid at the time of entering into the contract with her, which is Rs. 200. This premium amount is her profit from the call option contract. 

Let’s take a look at the cash flow of Ranjeet and Latika as a consequence of this call option contract. 

Scenario 3: Before the expiry date, say on July 20, 2020, the shares of Asian Paints are trading at Rs. 1,900 each.

Ranjeet’s point of view

• In this scenario, Ranjeet senses that the price trend is going up, just as he expected it would.
• But he does not want to wait till expiry to make a profit. He wants to profit off this uptrend right away.
• So, he does this thing – he sells his call option contract to another trader named Krishna through the stock exchange. This action is termed as squaring off a position.  
• Now, Ranjeet becomes the call option seller and Krishna is the call option buyer.
• Accordingly, Krishna pays a premium to Ranjeet. And since the price movements are in favor of Ranjeet’s view, he gets to charge a higher premium, say Rs. 350 (Rs. 35 per share x 10 shares).
• Once this trade is done, Ranjeet is left with a profit of Rs. 150 (Rs. 350 that he got from Krishna minus Rs. 200 that he paid to Latika).

Now let’s take a brief look at the cash flow of Ranjeet as a consequence of this call option trade.

Scenario 4: Before the expiry date, say on July 20, 2020, the shares of Asian Paints Limited are trading at Rs. 1,000 each.

Ranjeet’s point of view 

• In this scenario, Ranjeet senses that the price trend is going down, contrary to what he expected.
• Scared that it may go further down as the expiry date nears, Ranjeet wants to sell off his contract right away, so that he can limit his losses. 
• And so, he sells his call option contract to Krishna and squares off his position.
• As in the previous scenario, Ranjeet becomes the call option seller and Krishna is the call option buyer.
• Accordingly, Krishna pays a premium to Ranjeet. 
• But since the price movements are not in favor of Ranjeet’s view, he doesn’t get to charge a very high premium. Say he sells his call option contract to Krishna for a premium of only Rs. 50 (Rs. 5 per share x 10 shares).
• Once this call option trade is done, Ram is left with a loss of Rs. 150 (Rs. 200 that he paid to Latika minus Rs. 50 that he got from Krishna). 
• This is less than the loss of Rs. 200, which he would have made had he waited till expiry.

Here’s how the cash flow of Ranjeet as a consequence of this call option trade looks like.

Wrapping up

So, these are the details about how to calculate the payoffs for call options. We’ll leave you here with a quick fact. Mostly, traders actively participating in the options market don’t generally wait till the expiry to get to the call option payout part. They tend to square off their position quickly to enjoy short-term profits from the options trade. In the next chapter, we’ll see what happens when you trade put options.

A quick recap

• Unlike regular shares, options contracts have an expiry date. Typically options contracts expire on the last Thursday of every month. 
• In case the last Thursday of the month is a holiday, the contract will expire on the previous trading day.
• With respect to options contracts of a stock or an index, at any point in time, there are always contracts with three different expiries listed on the stock exchange: near month expiry, next month expiry and far month expiry.
• When you buy a call option, you can either hold it till expiry or square off your position.
• On expiry, your maximum possible loss is limited to the premium. But the maximum possible gain is potentially unlimited.
• When you sell a call option, your maximum possible gain is limited to the premium. But the maximum possible loss is potentially unlimited.