What is a Call Option?
A call option (CE) is a derivative contract where the buyer has the right but not an obligation to purchase the underlying asset at a predetermined price within a specific expiration date. The underlying asset can be a stock, bond, commodity, or any other financial instrument. The following are the few terms associated with the call option –
- Strike Price: The pre-decided price at which the option will be exercised.
- Exercise Date: The date on which the right has to be settled.
- Premium: The fee charged for the option.
For entering this contract, the buyer pays a premium to the seller for exercising it. If the underlying asset price rises, the buyer makes a profit. However, if the asset price falls, the buyer will not exercise the contract. Generally, this option is used to speculate to earn profit, or hedge to reduce the risk.
In India, all options are exercised as European options. A Call Option is denoted as CE.
How Does a Call Option Work?
Let us understand how the call option works with the help of an example where the underlying security is a stock. A single-call option contract gives the holder the right to buy 100 shares of ABC stock at INR 100, with an expiration date of three months. The trader can choose among the various expiration dates and strike prices. As the value of ABC stock rises, the price of the option contract also rises and vice versa. The buyer may hold the contract till the expiration date, on which they can take delivery of the 100 shares of ABC stock at the strike price. Also, they can sell the options contract anytime before the expiration date at the market price of the contract and earn profit from the difference in premium.
The buyer bears a cost called the premium to exercise the call option. On expiration, if the asset price is less than the strike price, the buyer loses the premium, which is the maximum loss.
So if the ABC stock trades at INR 100, the strike price is INR 100, and the premium cost is INR 2. At expiry, if the stock price increases to INR 110, then the profit the buyer makes is
Profit = 110 – (100+2) = INR 8 x 100 shares = INR 800 for one option contract.
On the other hand, if the stock price declines to INR 90 on expiry, then the buyer will not exercise the option to buy the shares, and the option expires. Thus, the buyer loses only INR 200 (INR 2 x 100 shares) for each contract. Thus, this is the benefit of options where the buyer only loses the premium if the option is not exercised.
Buying a Call Option
Buying a call option is also referred to as a long call option. The buyer purchases the option hoping that the underlying asset price will rise beyond the strike price before the expiration date. The profit the option holder earns is equal to the sales proceeds minus the strike price, premium, and transactional fees. The buyer may not exercise the option if the underlying asset price does not increase beyond the strike price. Thus, the buyer will suffer a loss equal to the premium amount.
Let’s assume that the stock ABC is trading at INR 50. A buyer purchases one option contract for INR 55 strike price for the stock ABC and the expiration date is one month. The stock price is anticipated to increase to INR 60 in the following month. The option holder retains the right to purchase 100 shares of ABC stock at INR 55 till the expiration date. Also, the premium per share is INR 2, where the buyer pays INR 200. This is the maximum amount that the buyer can suffer a loss.
Suppose if the price of the stock ABC rises to INR 60 in the following month, the buyer exercises the call option right to buy 100 shares at INR 55. It leads to a profit of INR 5, and a net profit of INR 3 (INR 5-2) for each share. On the other hand, if the ABC stock price does not rise beyond INR 55, on expiry the buyer will lose the premium paid (INR 200).
The below table helps to understand when the share price goes up or down, and how the buyer makes a profit. However, the losses are limited irrespective of the stock price falls.
|Price upon expiry||Profit from the call option(Strike – Spot – Premium paid)|
Selling a Call Option
Selling a call option is also referred to as a short call option, where the call option sellers are also known as writers. They sell call options with the hope that they become worthless at expiry and make money by receiving premiums paid to them. However, their profit will be reduced or result in a loss if the buyer exercises the option. In other words, this strategy leads to limited profit if the underlying security trades below the strike price and leads to substantial risk if trades above the strike price.
The following are two ways to sell call options –
- Covered Call Option: The seller actually owns the underlying asset, which protects them from a loss if the buyer exercises the call option and purchases it.
- Naked Call Option: The seller does not own the underlying asset and can sell it. But doing so will not protect them against potential losses.
Let’s assume that stock ABC has a price of INR 50. The seller anticipates that the stock price will fall in the following month. The seller writes one call option with INR 53 as the strike price and expiration date in a month. Also, the seller will receive a premium of INR 2 per share, where the total premium is INR 200.
If the ABC stock price increases to INR 55 within a month, the call option is considered to be exercised. Thus, the option writer will have to sell the shares at INR 53. As a result, the option writer will incur a loss of INR 200 (2 x 100 shares).
The below table will help you understand the profit and loss scenario when the share price moves up or down. The profit is limited to the premium amount but the losses are unlimited.
|Price upon expiry||Profit from the call option (Spot – Strike + Premium Received)|
Advantages and Disadvantages of a Call Option
The following are the advantages –
- Cost Effective: Investing in equity or other instruments requires a good capital amount to make a viable investment and earn good returns. However, traders must pay only a premium for buying this option which depends on the underlying asset. This becomes more affordable, which is cost-effective for anyone to buy it.
- Less Risk: Buying this option is less risky than investing directly in equity or other instruments. The losses are very limited to the premium amount paid to obtain the right to sell the call option.
- Earn Premium Through Covered Call: Even after buying this option contract, the trader can generate additional revenue by selling the call option in the secondary market. If the underlying asset which was bought had appreciated, the trader can write the call option where the strike price is the current market price and earn a premium on it. This transaction is referred to as the covered call in an options contract, enabling investors to earn additional profits.
The following are the disadvantages –
- Time Decay: This is a significant disadvantage when trading options. The value of the option premium decreases by some percentage each day, irrespective of the movement in the underlying asset.
- Higher Commissions: Options trading is more expensive than stock trading. This is because most brokers charge higher fees for trading options. However, some discount brokers provide an opportunity to trade with lower commissions.
Frequently Asked Questions
Buying a CE means the buyer is bullish i.e., they anticipate the security’s price will rise in the future.
The call options are ITM (in the money) when the stock price is above the strike price at the expiry. On the other hand, call option are OTM (out of the money) when the stock price is below the strike price at the expiration date.
The most important factors that influence the price of CE are strike price and market price. Also, political events can add uncertainty in the market, pushing the time value of the CE and hence the prices. Furthermore, if the interest rates are cut, it increases the present value of the strike price, reducing the gap between the strike price and the market price. Therefore, this will be negative for the CE.
A long call option is a standard call option where the buyer has the right but not an obligation to purchase an underlying asset at a specific price on a future date. This is a bullish market strategy with unlimited profit potential, but the losses are limited up to the premium paid.
The short call option means selling the call option because the trader is bearish about the underlying asset. This strategy leads to limited profit potential but the risk of unlimited loss.
You can exit the CE position when you have made profits, when the underlying asset has increased in price or when you no longer want to hold the long bullish position on the underlying asset.