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Thursday, February 29, 2024

What is a Call Option: Basics, How It Works, and Strategies

Understanding the fundamentals of call options is essential for anyone looking to navigate the world of financial contracts and investment strategies. In this comprehensive guide, we will delve into the definition, examples, and practical strategies associated with call options. Whether you’re a seasoned investor or a newcomer, this article aims to provide valuable insights into the dynamics of call options, emphasizing their basics and practical applications.

What is a Call Option?

A call option is a financial contract that grants the buyer the right, but not the obligation, to purchase a specific asset, such as a stock, bond, or commodity, at a predetermined price within a specified period. This period is known as the expiration date, and the agreed-upon price is the strike price. The buyer pays a premium for this right, and key terms associated with a call option include the strike price, expiration date, and premium.

Call Option Example: To illustrate, let’s consider an example. Assume that Gammon India stocks are currently priced at Rs. 100 per share. An investor, let’s call them B, owns 100 shares and expects the stock to remain below Rs. 120 in the next month. B explores call options and finds a call with a strike price of Rs. 120, trading at 40p per contract. B sells one call option, receiving Rs. 40 as a premium.

If the stock price surpasses Rs. 120, the option buyer can exercise the right, and B would have to sell the shares at Rs. 120 each. If the price doesn’t rise, B keeps the shares without affecting a sale.

Long Call Option and Short Call Option

  • Long Call Option: The most common strategy when buying call options is the long call. Investors employing this strategy anticipate a substantial increase in the market price of the underlying asset before the expiration date. They pay a premium for the option, speculating on potential profits.

    Example: Investor X buys a call option for stock ABC with a strike price of Rs. 55 and an expiration date in one month when the current price is Rs. 50. If ABC’s price rises to Rs. 60, X can buy 100 shares at Rs. 55 and sell them immediately at Rs. 60, making a profit of Rs. 5 per share.
  • Short Call Option: Conversely, the short call option involves selling an option with the obligation to purchase the underlying asset at a predetermined price. This strategy is suitable when an investor expects a moderate fall in the asset’s price. It generates upfront credit that may offset margin requirements.

    Example: Investor X writes a call option for stock ABC with a strike price of Rs. 53, receiving a premium of Rs. 200. If ABC’s price remains below Rs. 53, X gains the premium. If it rises to Rs. 55, X has to sell shares at Rs. 53, incurring a loss of Rs. 2 per share.

Difference Between Call Option and Put Option

  • Call Option: Provides the right to buy an underlying asset at a predetermined strike price on a specific date without an obligation. Investors anticipate an increase in price, and profits are unlimited as there is no ceiling to price rise.
  • Put Option: Offers the right to sell an underlying asset at a predetermined strike price on a particular date without any obligation. Investors anticipate a fall in price, and profits are limited as price decreases will eventually be arrested at zero.

When to Buy and Sell Call Options

  • Buying a Call Option: Investors buy call options when they expect a security’s price to rise before the expiration date. This strategy allows for leverage, potentially yielding substantial gains with a lower investment. Even if the security’s price falls, the investor only loses the premium paid.
  • Selling a Call Option: Investors sell call options when they anticipate a decline in the asset’s price. There are two methods – naked call option and covered call option. Naked call options involve selling without owning the underlying asset, posing significant risk. Covered call options use an underlying asset as coverage, reducing risk but limiting potential profits.

Understanding In-the-Money, At-the-Money, and Out-of-the-Money Call Options:

  • In-the-Money (ITM) Call Options: The market price is higher than the strike price.
  • At-the-Money (ATM) Call Options: The strike price and spot price are close.
  • Out-of-the-Money (OTM) Call Options: The market price is lower than the strike price.

Factors Influencing the Price of Call Options

Several factors impact call option prices, including:

  • Intrinsic Value: The difference between the underlying asset price and the strike price.
  • Time to Expiration: As the expiration date approaches, time value diminishes.
  • Implied Volatility: Market expectations for future price movements affect premium.
  • Interest Rates: Higher rates generally decrease call option premiums.
  • Greek Values: Metrics measuring sensitivity to changes in factors like asset price, volatility, interest rates, and time.

Significance of Time Value in Call Options

The option premium comprises intrinsic value and time value. Time value is based on the probability of the option becoming profitable. In-the-Money options have both intrinsic and time value, while Out-of-the-Money options only have time value.

Options Trading in India

  • Cash Settlement: In India, all options are cash-settled, and profits are adjusted in cash.
  • Index Call Options and Stock Call Options: Index call options involve buying an index, while stock call options focus on individual stocks.
  • Monthly and Weekly Expiry: Options on stocks have near-month, mid-month, and far-month contracts, with expiry on the last Thursday of the month. Weekly options aim to reduce risk by expiring every week.

European and American Call Options

  • European Call Option: Can only be exercised on the settlement date.
  • American Call Option: Can be exercised on or before the settlement date. Most options have shifted to being European options.

Key Takeaways

  • Call options provide the right to buy an underlying asset at a strike price on a future date.
  • Executing a call option is profitable when the strike price is lower than the market price at the time of expiry.
  • The market price of the call option is called a premium, influenced by factors like intrinsic value, time to expiration, implied volatility, interest rates, and Greek values.

Final Words

Trading options can be a valuable strategy to increase market exposure with limited funds. Options trading in India offers a way to participate in the markets with controlled risk. If you’re interested in exploring options trading, platforms like Angel One provide opportunities to trade options by opening a demat account online.

FAQs:

  1. When should you buy a call option?
    • Investors buy calls when optimistic about a stock, gaining leverage and limiting potential losses.
  2. When to sell the call option?
    • Sell a call option when expecting limited stock upside; the seller benefits if the stock doesn’t rise above the strike price.
  3. How do call options work?
    • A call option is a contract granting the right to buy a specific stock at a set price until a specified expiration date.
  4. What is a call option with an example?
    • A call option entitles the holder to purchase a stock, providing a deposit for a future purchase.
  5. Is Buying a Call Bullish or Bearish?
    • Buying calls is bullish as it profits from a rise in stock prices, while selling calls is bearish, benefiting if stocks don’t rise.

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