ET enlightens the reader on the difference between a call option seller or writer and a call option buyer. In this series of classroom, ET enlightens the reader on the difference between a call option seller or writer and a call option buyer.
What’s a call option?
An instrument that gives a buyer the right but not the obligation to purchase the asset underlying the call option at a preset price on a future date. The seller has the obligation to deliver the asset to the buyer at the predetermined price.
For example, you buy a Nifty 10,000 call expiring September 28 at Rs 112 a share (75 shares make a lot). The Nifty expires at say 10200, making the option in the money by Rs 88 (minus the cost of option paid by buyer). The seller is obliged to sell the Nifty to the buyer at 10000 even though the index is 10200.
Thus the buyer buys at 10000 and sells at 10200, making a gross gain of Rs 88 a share (minus cost of option) or Rs 6,600 a lot. In case Nifty expires at 9900 on September 28, the seller gets to pocket the Rs 100 of the Rs 112 premium paid by the buyer as the Nifty is out of money by Rs 100. In actuality , Nifty is cash settled with buyer and seller exchanging the difference.
So what is the view of a call buyer and seller?
The buyer believes the underlier will rise above the strike price or level she has purchased plus the premium paid to the seller. In the aforesaid case, for the buyer to profit, Nifty must rise above 10,112 on equity expiry.
So, the buyer holds a bullish view. The seller does not expect the Nifty to rise above 10,112. So, though not necessarily bearish, she thinks the market could move in a range. If that’s the case, she gets to pocket all or much of the premium paid to her by the buyer.
What’s the risk?
For the buyer, the maximum risk is losing the premium but the profit can be hefty. For example, if Nifty expires at 10,200, she makes Rs 88 on an investment of Rs 112 a share, a gross return of 79 per cent, ex brokerage, STT and stamp duty.
For the seller, the profit is limited but loss is unlimited. The maximum profit is premium paid by buyer. That accrues if the Nifty expires at or below the strike sold. The break-even for buyer is the strike plus premium paid; in this case, its 10,112.
Who is the stronger hand?
The seller, who normally has more money (than the buyer) and who can also sell a call against the stock she holds to offset the derivatives loss. She can also offset this by selling a put of similar price or buying futures on the asset underlying the call.