Options Theory for Professional Trading
A Special Agreement
There are two types of options – The Call option and the Put option. You can be a buyer or seller of these options. Based on what you choose to do, the P&L profile changes. Of course we will get into the P&L profile at a much later stage. For now, let us understand what “The Call Option” means. In fact the best way to understand the call option is to first deal with a tangible real world example, once we understand this example we will extrapolate the same to stock markets. So let’s get started.
Consider this situation; there are two good friends, Ajay and Venu. Ajay is actively evaluating an opportunity to buy 1 acre of land that Venu owns. The land is valued at Rs.500,000/-. Ajay has been informed that in the next 6 months, a new highway project is likely to be sanctioned near the land that Venu owns. If the highway indeed comes up, the valuation of the land is bound to increase and therefore Ajay would benefit from the investment he would make today. However if the ‘highway news’ turns out to be a rumor- which means Ajay buys the land from Venu today and there is no highway tomorrow, then Ajay would be stuck with a useless piece of land!
So what should Ajay do? Clearly this situation has put Ajay in a dilemma as he is uncertain whether to buy the land from Venu or not. While Ajay is muddled in this thought, Venu is quite clear about selling the land if Ajay is willing to buy.
Ajay wants to play it safe, he thinks through the whole situation and finally proposes a special structured arrangement to Venu, which Ajay believes is a win-win for both of them, the details of the arrangement is as follows –
Ajay pays an upfront fee of Rs.100,000/- today. Consider this as a non refundable agreement fees that Ajay pays
Against this fees, Venu agrees to sell the land after 6 months to Ajay
The price of the sale( which is expected 6 months later) is fixed today at Rs.500,000/-
Because Ajay has paid an upfront fee, only he can call off the deal at the end of 6 months (if he wants to that is), Venu cannot
In the event Ajay calls off the deal at the end of 6 months, Venu gets to keep the upfront fees
So what do you think about this special agreement? Who do you think is smarter here – Is it Ajay for proposing such a tricky agreement or Venu for accepting such an agreement? Well, the answer to these questions is not easy to answer, unless you analyze the details of the agreement thoroughly. I would suggest you read through the example carefully (it also forms the basis to understand options) – Ajay has plotted an extremely clever deal here! In fact this deal has many faces to it.
Let us break down Ajay’s proposal to understand some details –
By paying an agreement fee of Rs.100,000/-, Ajay is binding Venu into an obligation. He is forcing Venu to lock the land for him for the next 6 months
Ajay is fixing the sale price of the land based on today’s price i.e Rs.500,000/- which means irrespective of what the price would be 6 months later he gets to buy the land at today’s price. Do note, he is fixing a price and paying an additional Rs.100,000/- today
At the end of the 6 months, if Ajay does not want to buy the land he has the right to say ‘no’ to Venu, but since Venu has taken the agreement fee from Ajay, Venu will not be in a position to say no to Ajay
The agreement fee is non negotiable, non refundable
Now, after initiating this agreement both Ajay and Venu have to wait for the next 6 months to figure out what would actually happen. Clearly, the price of the land will vary based on the outcome of the ‘highway project’. However irrespective of what happens to the highway, there are only three possible outcomes –
Once the highway project comes up, the price of the land would go up, say it shoots up to Rs.10,00,000/-
The highway project does not come up, people are disappointed, the land price collapses, say to Rs.300,000/-
Nothing happens, price stays flat at Rs.500,000/-
I’m certain there could be no other possible outcomes that can occur apart from the three mentioned above.
We will now step into Ajay’s shoes and think through what he would do in each of the above situations.
Scenario 1 – Price goes up to Rs.10,00,000/-
Since the highway project has come up as per Ajay’s expectation, the land price has also increased. Remember as per the agreement, Ajay has the right to call off the deal at the end of 6 months. Now, with the increase in the land price, do you think Ajay will call off the deal? Not really, because the dynamics of the sale are in Ajay’s favor –
Current Market price of the land = Rs.10,00,000/-
Sale agreement value = Rs.500,000/-
This means Ajay now enjoys the right to buy a piece of land at Rs.500,000/- when in the open market the same land is selling at a much higher value of – Rs.10,00,000/-. Clearly Ajay is making a steal deal here. Hence he would go ahead and demand Venu to sell him the land. Venu is obligated to sell him the land at a lesser value, simply because he had accepted Rs.100,000/- agreement fees from Ajay 6 months earlier.
So how much money is Ajay making? Well, here is the math –
Buy Price = Rs.500,000/-
Add: Agreement Fees = Rs.100,000/- (remember this is a non refundable amount)
Total Expense = 500,000 + 100,000 = 600,000/-
Current Market of the land = Rs.10,00,000/-
Hence his profit is Rs.10,00,000 – Rs.600,000 = Rs.400,000/-
Another way to look at this is – For an initial cash commitment of Rs.100,000/- Ajay is now making 4 times the money! Venu even though very clearly knows that the value of the land is much higher in the open market, is forced to sell it at a much lower price to Ajay. The profit that Ajay makes (Rs.400,000/-) is exactly the notional loss that Venu would incur.
Scenario 2 – Price goes down to Rs.300,000/-
It turns out that the highway project was just a rumour, and nothing really is expected to come out of the whole thing. People are disappointed and hence there is a sudden rush to sell out the land. As a result, the price of the land goes down to Rs.300,000/-.
So what do you think Ajay will do now? Clearly it does not make sense to buy the land, hence he would walk away from the deal. Here is the math that explains why it does not make sense to buy the land –
Remember the sale price is fixed at Rs.500,000/-, 6 months ago. Hence if Ajay has to buy the land he has to shell out Rs.500,000/- plus he had paid Rs.100,000/- towards the agreement fees. Which means he is in effect paying Rs.600,000/- to buy a piece of land worth just Rs.300,000/-. Clearly this would not make sense to Ajay, since he has the right to call of the deal, he would simply walk away from it and would not buy the land. However do note, as per the agreement Ajay has to let go of Rs.100,000/-, which Venu gets to pocket.
Scenario 3 – Price stays at Rs.500,000/-
For whatever reasons after 6 months the price stays at Rs.500,000/- and does not really change. What do you think Ajay will do? Well, he will obviously walk away from the deal and would not buy the land. Why you may ask, well here is the math –
Cost of Land = Rs.500,000/-
Agreement Fee = Rs.100,000/-
Total = Rs.600,000/-
Value of the land in open market = Rs.500,000/-
Clearly it does not make sense to buy a piece of land at Rs.600,000/- when it is worth Rs.500,000/-. Do note, since Ajay has already committed 1lk, he could still buy the land, but ends up paying Rs 1lk extra in this process. For this reason Ajay will call off the deal and in the process let go of the agreement fee of Rs.100,000/- (which Venu obviously pockets).
I hope you have understood this transaction clearly, and if you have then it is good news as through the example you already know how the call options work! But let us not hurry to extrapolate this to the stock markets; we will spend some more time with the Ajay-Venu transaction.