Let’s talk about Call Options.
Using an example from – you guessed it – Cricket!
Assume India is playing a T-20 Match.
India bats first.
If we bet on India’s score being above or below 160, with the losing party paying the difference, this is very similar to a future contract
You say – India will score > 160
I say – India’s score will be < 160
If India scores 145, you pay me 15.
If India scores 178, I pay you 18.
Now assume that we bet before the start of the innings, but DEACTIVATE the bet for now.
And I give you a CHOICE – to activate/enforce the bet AFTER the innings.
Think about it – you will only enforce it if you win. Else, you won’t.
So it is a one-sided bet. You can win, but cannot lose. I can only lose, but not win.
Surely I will not give you this choice for free. Say I charge you Rs 10, that you pay me to get this right.
Now think of scenarios.
India scores 120. If you enforce the bet, you lose. Instead, you will forego the Rs 10 paid (your max loss, and my max gain)
India scores 220. You will enforce, since your payoff will be Rs 50 [(220-160) -10]. I have to pay if you choose to enforce the bet.
This is how a Call option works. You pay a premium of Rs 10 to buy the option. You have a potential large upside with a limited downside (Rs 10).
I have the exact opposite profile, as the seller of this option
Think of an option as a right to enforce a bet.
160 is the strike price, and India’s final score is the Spot Price on Expiry
While this is an over-simplification, looking at payoffs at the expiry, we can explain more concepts in options using this example. More on that soon.
That’s it in this week. Keep Learning.
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