Understanding Call Options using Ramlal the Kirana Store Owner’s example
After Ramlal, the Kirana Store Owner signed up a contract with his customer, Seema he realized the power of such contracts.
Now he has another idea which he believes is called Call Option by Stock Brokers.
His idea is as explained below:-
1) Ramlal has a stock of 100 packs of Maggi priced at Rs 10 each
2) The demand for Maggi has been sky rocketing and there has been talk in the media of an impending Price Hike.
3) This situation gives Ramlal an idea. He tells one of his favorite customer Shilpa that since she has been a regular customer of his, he wishes to reward her with a scheme that would fix the price of Maggi for the next 6 months
4) Under the Scheme he will fix the Price of a Maggi Pack at the Current Price of Rs 10 each for the next 6 months whatever be the amount of Price Hike
5) For this service, he would charge Shilpa a token amount of 25 paise per day equalling to Rs 45 for a period of 6 months or 180 days.
6) Shilpa realizes that for a mere Rs 45 she was getting Price guarantee for 6 months.
7) Shilpa expects that due to the shortage, prices most likely would go up by Rs 2 per pack which means an additional expense of nearly Rs 360 in 6 months.
8) As against Rs 360, this scheme appears cheap at Rs 45. So she confirms her participation with Ramlal.
9) Ramlal on the other hand is happy as well because he strongly believes that the price won’t go up and will continue to be Rs 10 per pack of Maggi
10) So he believes this scheme gives him the opportunity to earn an additional income of Rs 45 in 6 months. He can multiply his earnings by selling this scheme to several of his loyal customers.
11) This scheme of giving Shilpa “the Right to Buy” at Rs 10/- is nothing other than a “Call Option”.
12) The Rs 10 price at which she has a right to buy is the “Strike Price”. The Rs 45 for 3 months that Ramlal charges is the Premium for the Call Option.
Hope the above example has clarified the concept of “Call Option”, “Strike Price” & Premium.