Derivatives: Call Options(2)
I will start by describing the characteristics of a call option using an example; I will also use the example to introduce some other concepts about options. A call option is a contract in which the long has the right to buy a stock from the short at a predetermined price called the exercise price, regardless of the market price at a predetermined date.
Mr. Rock believes that UBA is going to release a superlative result next week, which will boost the stock price, but he presently does not have the money to invest and he is expecting some money in one month. Miss Stone has 1000 units of UBA and does not believe that UBA stock price will appreciate because of the bearish nature of the market, which was occasioned by foreign portfolio managers pulling out of it. UBA is currently selling at N12 per share. Miss Stone decides to write a call option for 1000 units of UBA with an exercise price of N14 to expire in 30 days with an option premium of N3 per share.
Remember that one option cover a multiple number of shares of an underlying stock depending on the rules of the exchange. In our example, an option covers 1000 units of a stock. Mr. Rock is the long (insured investor) while Miss Stone is the short (insurance investor). At the initiation of the contract Mr. Rock pays Miss Stone N3000 (N3 x 1000 units) with the understanding that he has the right to purchase 1000 units of UBA from her at N14 per share at the end of 30 days.
Options usually have a time frame before expiry. The standard duration is 30 days or one month, but it may be shorter or longer. At the end of the period, the long may or may not exercise the right to buy the underlying asset. Options may also be American or European. In American options, the long can exercise (the process of terminating the contract) his rights before the expiry date while in European options, the long has to wait till the expiry date before terminating it. There are other complex ones like Asian options. The nomenclature of these options does not mean that they originated from those places or that they are used only in those places.
In our example the option is European and is for 30 days. Mr. Rock and Miss Stone set the exercise price at N14 and Mr. Rock pays Miss Stone N3 per share as the option premium. This means that at the end of 30 days Mr. Rock can decide to exercise the option if it is in his favor or let the option expire without exercising his rights if it is not in his favor. We have two possible scenarios playing out here. UBA shares may go for more than N14 at the end of the period. Alternatively, they may be selling at or below N14 per share. Remember that N14 is the exercise price while N12 is the current price.
If the price of UBA is less than N14, say N11; Mr. Rock will not exercise it because it is not in his favor. He will have to go to the market to purchase his 1000 units of UBA at N1100 at the end of 30 days if he is still interested. Based on this contract, Mr. Stone lost a total of N3 per share, which he paid to initiate the contract and he will not have to pay the N14 per share to buy from Miss Stone. The contract expires worthless. If he knew the price was going to fall, he would not have bought the call option.
If the price of UBA has risen to N19, it is in his favor and he will exercise it. This means that he will pay Miss Stone the exercise price, that is, N14 per share (total of N14000) and collect an asset worth N19 per share (worth a total of N19000). Mr. Stone paid N3 to initiate the contract and an additional N14 to exercise his right, a total of N17 and received a stock worth N19 in return, making a total profit of N2 per share. This profitable transaction may also be viewed this way. Mr. Stone paid N3 for the option, which was worth N5 at the end of day, that is, N19 minus N14. He will be happy because he made a good move.
Miss Stone may not be too happy with the second scenario, but then, insurance companies are not always happy when an insured individual makes a claim on them. If Miss Stone had purchased UBA earlier, maybe at a price of N7, then it may not be too bad. She will definitely feel the pinch if she never had UBA in her portfolio in the first instance. Then she will have to go and purchase the stock at N19 and receive N14 in return. But it should be remembered that she had initially collected N3 from Mr. Stone at the beginning, so her total loss will then be restricted to N2 per share.
It should be noted that the prices I used are arbitrary as there are ways of pricing options using the Black-Merton-Scholes model, which I will not describe here. There also ways of using put-call parity relations to make sure the options are well priced to prevent undue arbitrage advantage. These techniques are beyond the scope of this blog.