Let’s continue with the same example which we discussed in the Futures section. In the example, Sita had agreed to buy Noor’s 2 BHK flat after 6 months at a price of Rs 1.1 crore. Let us modify the example slightly to understand options. Recall that though Sita likes Noor’s apartment and is keen on buying it, as her money is locked in fixed deposit maturing in 6 months she is not able to pay for the apartment immediately. Sita is also concerned that house prices will rise in the future and is keen to lock in the price as of today. Noor is selling the house so that the proceeds can be utilized to set up a catering business. She is also keen to seal the deal with Sita, but needs some time to find a suitable rented accommodation. Thus it made sense for both of them to enter into a futures contract executable after 6 months.
Let’s suppose Noor is keen to sell the apartment right away and move out. If she has to wait for 6 months to receive the purchase consideration and vacate the apartment, then Noor expects to be adequately compensated for the same. The compensation is because Noor will have to maintain the apartment for 6 months and is liable to pay property taxes, maintenance expenses etc.
Let’s assume Sita agrees to pay Rs.5 lakh immediately to Noor. By doing so, Sita is buying the right to buy Noor’s apartment after 6 months at a predetermined price of Rs 1.1 crore and Noor is charging her some premium to grant this right. This is an example of call option. Sita is entering into a call option with Noor, this gives her the right to buy Noor’s apartment after 6 months; this is called the long position. Noor is giving Sita the right to buy her apartment and holds the short position. Predetermined price of the underlying apartment is called strike price. In this example strike price of the call option is Rs 1.1 crore and maturity period is 6 months.