Gain or Loss
Assuming no transaction costs the purchase of call option primarily requires the payment of premium to the option writer. Assuming premium (P) paid is Rs 5 per share, the gain (G) to the call-holder of Reliance (assuming 51 = Rs 140) will he reduced by the amount of Pas shown by Equation 5.2
G= Max (S1 - E. 0) - P
= (Rs 140 - Rs 125) - Rs 5 = Rs 10
In case the value of the share is Rs 120, the loss to the call-holder would be Rs 5 (equivalent to the amount of the premium paid). His loss will not increase to Rs 10 (E - S1= Rs 125 - Rs 120 = Rs 5 + Rs 5 premium paid) because the call-holder is under no obligation to buy the share. He will obviously not buy the share at Rs 125 whose market price is Rs 120. Therefore, it can be generalized that the loss is equal to the premium paid whenever S1 < E When S1 > E, gain would be as shown by Equation 5.2. This is illustrated may be noted from that the call-holder suffers a loss until the S1 rises to the point where it equals E + P. This point of equality can be referred to as-break-even point (BEP), given by Equation 5.3.
BEP = S1 - (E + P) = zero
Beyond the BEP, the call-holder would gain with rise in share prices.
In contrast, the writer of the call option gains as long as the price of the share (S1) on the date of. maturity is less than the sum of exercise price and premium received. Equation 5.4 indicates gain to the writer of the call option.
S1 > (E + P) subject to (S1 - E) < P
Continuing with the call option writer gains if the price of tile share on the date of expiration is less than Rs 150. that is Rs 125, E + Rs 5, P. However. the maximum gain would be Rs 5 only (equivalent to the option premium received) and this will accrue to him if S1 < E, at the maturity. The profit margin would be lower if S1 > E, but less than E + P. Assume Reliance share's market value is Rs 128, The call-holder gains by exercising his right to buy Reliance share at Rs 125. The call option writer's profit margin would be reduced by Rs 3 as he would have to buy the share at Rs 128 and sell at Rs 125, his profit margin would be Rs 2 (P, Rs 5 - Rs 3, S1 - E).
Whereas the call writer's profits are limited to Rs 5 per share, his losses can rise sharply with increase in the market price of the share. Suppose. Reliance share's market price jumps to R.s 200, his loss will be Rs 70 per share (S1 - E + P = Rs 200 - Rs 125 + Rs 5), the profit or loss position of the call option writer.
The call writer will be at the BEP when S1 = E + P. In Example 5.1, he would be at break-even when share price is Rs 130 = Rs 125, E + Rs 5, P.