"Understanding Call and Put Options: How to Calculate Profit and Loss with Real-life Examples"

How to solve call option and put option problems

Buying call option:

Buying a call option is right to buy underlying asset at exercise price on future date. Call option will be exercised by the buyer of option when spot price is more than exercise price.

Example: If you buy call option at exercise price of 200 by paying premium of  10, it means you have right to buy at  200 irrespective price of underlying share. Suppose price of share in spot market goes up to  250, you will exercise your option to buy the underlying share at  200 and thus get the benefit of  50 and after deducting premium of  10 your net benefit will be  40.

On the other hand it price of share in spot market falls to  150, then it is beneficial to buy share in spot market and you will laps your option. The only loss to you is premium you have paid i.e.  10.

Thus, a person will normally buy a call option when he anticipates that prices of shares will increase in future.

Selling call option:

 Selling/writing a call option is 'obligation to sell' at exercise price on future date. As we have obligation to sell at exercise price, the buyer of the option will exercise the option when price is more than exercise price. (Remember  it is buyer who will always exercise the option, as a seller of option you cannot exercise the option as you have obligation to sell and not right to sell)

Example: If you sell a call option at exercise price of  200 by receiving premium of 10, it means you take obligation to sell at 200 irrespective price of underlying share. So whether price move upward or downward you made fix income of  10.

Suppose price of share in spot market goes up to  250, buyer of option will exercise the option to buy the underlying share at  200 and as you have obligation to sell at 7 200 you will have to sell it at  200. Thus, you loss  50 and after setting off premium that you have received of  10 your net loss will be  40.

On the other hand if price of share in spot market falls to  150, then buyer of option will not exercise his option as it will be beneficial for him to purchase the share from spot instead of purchasing from you at  200. Thus, he will lapse his option and you will not incur any loss on this transaction. But you make profit of  10, the premium you already received.

Thus, as seller of call option we will incur loss if the price rises above exercise price. But for selling an option we will receive a premium and that is our gain.

If price fall the buyer will not exercise option and premium received by you will be gain in contract.

Buying a put option:

 Buying a put option is right to sell' underlying asset at exercise price on future date.

In put option bought we buy the right to sale at exercise price underlying asset on future date. Thus, person who sale put option is buyer of option. He buys the 'right to sale' by paying a premium.

Put option will be exercised by the buyer of option when spot price is less than exercise price. Thus, a person will normally buy a put option when he anticipates that prices of shares will fall in future. But as future is uncertain price may increase also.

Selling a put option:

 Selling/writing a put option is obligation to buy underlying asset at exercise price on future date.

In 'put option sold' we sell the obligation to 'buy at exercise price' underlying asset on future date. Thus, person who sale put option is seller of option. He sells the 'obligation to buy by receiving a premium.

As we have obligation to buy at exercise price, the buyer of the option will exercise the option when price is less than exercise price. (Remember it is buyer who will always exercise the option, as seller of option we cannot exercise the option as we have obligation to buy and not right to buy)

Thus, as seller of option we will incur loss as price falls below exercise price.

But for selling an option we will receive a premium and that is our gain. If price increase the buyer will not exercise option and premium received by you will be gain in contract.

The above discussion is given for the understanding of the students as to how 'option contracts' are traded.

Example: If you buy call option at exercise price of 200 by paying premium of  10, it means you have right to buy at  200 irrespective price of underlying share. Suppose price of share in spot market goes up to  250, you will exercise your option to buy the underlying share at  200 and thus get the benefit of  50 and after deducting premium of  10 your net benefit will be  40.

On the other hand if price of share in spot market falls to  150, then it is beneficial to buy share in spot market and you will laps your option. The only loss to you is premium you have paid i.e.  10.

Thus, a person will normally buy a call option when he anticipates that prices of shares will increase in future.