Call Options Basics and How It Works in Practice


How exactly do options work? We have all heard of call and put options and options trading. But how to trade options and what are the key features of options trading in India. Let us first understand what call options is and then let us get deeper into call options with an example.

What is a call option?

A call option is a right to buy without an obligation to buy. So if you have a call option on TCS then you have the right to buy TCS but no obligation to buy TCS at a pre-determined price. For example, if you have bought a TCS 1-month 2700 call option at a price of Rs.45. On the settlement day if the price of TCS is Rs.2850, the option is profitable to you. But if on that date the price of TCS is Rs.2500 then you are not interested in buying TCS at 2700 when you can buy it in the open market at Rs.2500. For this right without obligation you pay a premium of Rs.45, which will be your sunk cost.

Understanding option trading in India…

In India all options are cash settled! What does that mean? It means that on the settlement date the profits will be adjusted in cash. Just because you have a TCS call option you cannot go to the exchange and demand that you get delivery of shares of TCS. Call options will be available in near-month, mid-month and far-month contracts. Remember, all call option contracts will expire on the last Thursday of the month.


What are Index call option and stock call options?

An index call option is the right to buy an index and the profit/loss will depend on the movement in the index value. Thus you have Nifty Calls, Bank Nifty calls etc. Stock options are options on individual stocks. Thus you have call options on Reliance Industries, Tata Steel, Infosys, and Adani SEZ etc. The principle of trading call options in both cases is the same. You buy call options when you expect the price of the stock or index to go up.

What are a European Call Option and an American Call option?

Before understanding European and American call option, let us first understand the concept of exercise of call option. When you buy a call option, you have two choices in front of you. Either you can reverse a call option (sell if you have bought it and buy if you have sold it) in the market or you can go to the exchange and exercise the call option. An option that can only be exercised on the settlement date is called a European option while an American option can be exercised on or before the settlement date. In the past, stock options were American while Index options were European. Now all options have shifted to being European options only.

What are weekly call options and what are monthly call options?

Monthly call options are the normal options that expire on the last Thursday of the month which are popularly trading. Recently, SEBI and the exchanges introduced a new product called weekly options specifically with respect to Bank Nifty. The idea was to reduce the risk of options by making the expiry each week. These weekly options have attracted quite a bit of interest from traders in the recent past.

What are ITM and OTM call options?

This is a very important classification when it comes to options. In-the-money (ITM) call options are those where the market price is higher than the strike price. The Out of the money (OTM) call option is one where the market price is lower than the strike price. If market price of Infosys is Rs.1000, then 980 Call Option will be ITM while 1020 Call Option will be OTM.

When it comes to call options, what is time value?

The option premium, as we saw earlier, is the price that the buyer pays to the seller for getting the right to buy without the obligation to buy. This option premium has 2 components viz. time value and intrinsic value. The intrinsic value is the price profit while the time value is the probability that the market is assigning to the option becoming profitable. All ITM options will have intrinsic value and time value while OTM options will only have time value.

Can we understand this with a call option example?

Assume that Infosys is quoting at Rs.1000. Let us look at various scenarios of call option strike prices and how the split of time value and intrinsic value is worked out…

Strike Price

Premium

Expiry

ITM/OTM

Intrinsic Val

Time Value

940 Call

115

Jan-2018

ITM

60

45

960 Call

93

Jan-2018

ITM

40

53

980 Call

61

Jan-2018

ITM

20

41

1000 Call

38

Jan-2018

ATM

0

38

1020 Call

29

Jan-2018

OTM

0

29

1040 Call

22

Jan-2018

OTM

0

22

1060 Call

14

Jan-2018

OTM

0

14

From the above table is clear that OTM call options only have time value while ITM options have time value and intrinsic value.



What influences the price of the call options?

There are various factors that influence the price of the call option. Of course, the strike price and the market price are very important factors. Political events that add to uncertainty and volatility in the market may also push up the time value of call options and therefore the price of these options. Similarly, if interest rates are cut then it increases the present value of the strike price and reduces the gap between the strike price and the market price. Thus it will be negative for call options.

As we have seen, options trading in India offer a good way to participate in the markets with limited risk..