Accounting for Call Option and Put Option

Call Option

Call Option is the futures contract that the buyer has the right to buy and seller has obligation to sell assets at a specific price. It means that the buyer may or may not buy the assets in the future as the market price drop below the contract price. However, the seller does not have the option but has obligation to sell even the market price increase higher than the contract price.

It sounds good for the buyer, but in order to sign this contract, the buyer must pay a premium. It is the amount that the buyer can lose when they decide not to exercise the contract. And it is the amount the seller receives in exchange for secure the price for buyers.

The call option can be used to buy and sell stock, bonds, commodity which is considered as the underlying assets.

Call Option Feature

• The buyer can exercise the option before the expiration date
• Agreed price in the contract is known as “Strike Price”
• The seller expect the share price to decrease below the strike price so that buyer will not exercise the contract and seller can get the premium.
• The buyer expects the share price to increase above the strike so that they can purchase at a lower price and make a profit.
• The maximum loss of the buyer is the premium while the profit is unlimited.
• The maximum profit of the seller is the premium while the loss is unlimited.
• Buyer’s profit is the seller’s loss.

Gain/Loss on Call Option

Gain/Loss is the comparison between the exercise price and the market price.

 Gain (Loss) = Market Price – Exercise Price
• Gain for buyer when market price more than the exercise price
• Gain for seller when market price less than the exercise price

Call Option Example

Mr. A purchases a call option from company ABC which allows him to purchase the share at \$ 1,000 per share and it will expire within 3rd year. Mr. A paid a call premium of \$ 10 per share and he purchases 2,000 shares.

• At the end of 1st year, share price is \$ 1,008
• At the end of 2nd year, share price is 1,015
• On the purchasing date, Mr. A paid \$ 20,000 to company ABC. The fair value of the call option contract equals \$ 20,000.

Company ABC will make the following journal entry

Account Debit Credit
Cash at Bank 20,000
Call Option Liabilities 20,000

Mr. A will make the following journal

Account Debit Credit
Call Option Assets 20,000
Cash at Bank 20,000
• At the end of 1st year, the share price equals \$ 1,008 per share.

Calculate Gain/Loss:

(1,008 * 2,000) – [20,000 + (1,000*2,000)] = 2,016,000 – 2,020,000 = \$ 4,000

So it means buyer will lose \$ 4,000 if he exercise the option and seller will gain \$ 4,000

• ABC will record the following:
Account Debit Credit
Call Option Liabilities 4,000
Fair Value Gain 4,000
• A record the premium as the asset, so when its value decreases, he needs to record fair value loss. Mr. A will record the following:
Account Debit Credit
Fair Value Loss 4,000
Call Option Assets 4,000

At the end of 2nd year, share price equal to 1015 per share.

Calculate Gain/Loss:

(1,015 * 2,000) – [20,000 + (1,000*2,000)] = 2,030,000 – 2,020,000 = (\$ 10,000)

It means the buyer will gain \$ 10,000 if he exercises the option and the seller loss \$ 10,000

ABC also receive the cash to exercise the call option from Mr. A: \$ 1,000 per share * 2,000 share = \$ 2,000,0000

• ABC will record the following:
Account Debit Credit
Call Option Liabilities 16,000
Fair Value Gain 4,000
Fair Value Loss 10,000
Equity – Paid-In Capital 30,000

We separate the Fair value gain \$ 4,000 for easy understanding. We can debit far value loss \$ 14,000.

Account Debit Credit
Cash at Bank 2,000,000
Shares Equity 2,000,000
• Mr. A will record the following:
Account Debit Credit
Investment 30,000
Call Option Asset 16,000
Fair Value Gain 10,000
Fair Value Loss 4,000
Account Debit Credit
Investment 2,000,000
Cash 2,000,000

Put Option

Put Option is the futures contract that gives the right to the holder to sell the underlying asset at a specific price within a time period. Opposite from call option, put option protects the holder from a share price decrease. Both seller and buyer make a contract to sell the stock at an agreed price (strike price). However, the holder has the option to sell while the buyer has the obligation to purchase. So the holder is the one who decides if the transaction happens or not.

When the share price decrease below the strike price, holder can go to the issuer to exercise the put option. It means the holder will force the issuer to buy the share at strike price while the market price is lower. However, if the share does not drop below strike price, the holder will not execute the option, but they have to pay the premium to issuer.

Put Option Feature

• The option holder can exercise the option before the expiration date
• Agreed price in the contract is known as “Strike Price”
• The issuer expects the share price to increase above the strike price so that holder will not exercise the contract and issuer can get the premium.
• The holder expects the share price to decrease below the strike so that they can sell at a higher price (strike price) and make a profit.
• The maximum loss of the holder is the premium while the profit is unlimited.
• The maximum profit of the issuer is the premium while the loss is unlimited.
• Holder’s profit is the issuer’s loss.