The call of the options
An option is a kind of derivative that gives you the right to buy or sell a particular asset at a predetermined price at a fixed date in the future. However, it does not give you the obligation to exercise the right. Options are available for a variety of assets, including stocks, gold, petroleum, wheat and so on.
There are two types of options – call and put options. The call option definition is that it’s an instrument that gives you the right, but not the obligation, to buy something. A put option gives you the right, but not the obligation, to sell something.
What is call option in share market?
Call and put options were introduced in the Indian stock markets in 2001-2. Trading call options in stocks allow you to take advantage of price movements without having to expend large amounts of capital and with considerably reduced risk.
Let’s see how trading in these is beneficial with an example. Say you expect the share price of a specific company ABC to go up from Rs 100 to Rs 150 in the future. You want to benefit by trading call options. So you buy 1,000 at a strike price of Rs 100. When the share prices move up to Rs 150, you can exercise your right to purchase the shares at Rs 100. Thus you will be able to make a profit of Rs 50,000, or (150-100) x 1,000. If on the other hand, if the price goes down to Rs 50, you can choose not to exercise your right and avoid losing Rs 50,000. The only loss you will incur in this case is the premium that you have to pay for the options contract.
The leverage advantage
Premiums are the price you pay to enter into the contract. Various factors affect the premium, but it is only a fraction of the value of the underlying asset. This allows you to trade much higher volumes with a given amount of capital.
If you invest Rs 10 lakh in stocks and prices go up by 10 per cent, you stand to make gains of Rs 1 lakh. However, with the same amount of capital, you will be able to trade much higher volumes with call options — you can enter into Rs 90 lakh worth of transactions. The only amount you need to pay upfront is the premium, which we are assuming here is 10 percent. If stock prices go up by 10 percent, your gains would be Rs 9 lakh! So there is a definite advantage of trading in options
Exercise at will
Call options contracts are available for 1, 2 or 3 months. However, you can exit the contract at any time before the end of the expiry period.
If you are a buyer, you can exit at any time if prices turn unfavourable or you want to book profits. Similarly, the seller or the `writer’ too has the option of exiting the contract to cut losses. However, the seller has to pay a premium to exit, since the premium changes according to the situation. From the seller’s viewpoint, when prices turn unfavourable, and it’s no longer worth exercising the contract, this is called `out-of-the-money’. In the case of the buyer, the situation is `in-the-money’ because he stands to make money by exercising the contract. So the premium he expects will be higher. The difference between the premium paid and premium received will be the loss in the case of the seller and profit in the case of the buyer.
There are three ways in which this type of contract can be settled. One is to square off the transaction – that is you can buy put options for the same stock at the same price. The difference between the premiums paid for the call and put options will be your profits/ losses. Another option is to sell. The third is a settlement at the strike price at the end of the expiry period.
How to buy call options
You can buy call options in the same way as you purchase stocks; through your broker after paying a premium. This premium then goes to the exchange and eventually finds its way to the seller or writer. While learning about how to buy call options, you should remember that not all stocks have stock options. Options contracts are available for only select securities – around 175 of them.
You can also purchase these for indices. If you think an index like the Nifty 50 is going to move up in the future, you can purchase call options on it and can turn in a profit. Index options tend to be less risky since you would be investing in a basket of stocks, which is better than putting all your eggs in one basket.
There are several advantages of trading in call options. You can trade much larger volumes for the same amount, the potential losses are limited to the premium that you have paid, plus it also allows you to trade in shares that would otherwise be too expensive to buy. These work best in a bullish market, enabling you to profit from any increase in share prices. Put options generally work better in a bear market, allowing the buyers to benefit from a downtrend in prices.
Potential losses may be smaller in call options than in direct investment in stocks, but you still have to get the timing right to make money.
Frequently Asked Questions
How does a call option work?
In the derivative market, call options give the holders a right to buy an underlying at a pre-decided price on a future date, known as an expiration date. Trading call options allow buyers to hedge against future price rise, especially when the market is bullish. It safeguards their interest if the asset price rises unexpectedly in the future market.
With a long call option, you have the following three options,
- Wait for the call options to expire
- Sell it before the expiration date
- Exercise the call option and get delivery of the underlying
What happens at the expiration of a call option?
If around the expiration date the market price is below the strike price the option will expire worthlessly. When an option approaches the expiration date, several things can happen. As the expiration date nears, the option losses its value fast. As a result, most options are traded before the expiration date. If your call option expires on the money, you will end paying a higher price to pay for the stocks along with the brokerage charges.
Can I sell a call option before expiry?
Yes, selling you call options before the expiration date is possible, especially if it is still in the money, and you expect the market will not change significantly before the expiration date.
If you don’t trade your option will either expire valueless or will get automatically executed.
To trade in call options, you need to build a clear understanding of how call options work.
When should you sell a call option?
The decision should depend on the market condition. Most traders will trade the options when they are in money before their expiration date. But when you can sell, however, will depend on the types of call options like the American type call options can be traded anytime between purchase date and expiration date, but European-style call options are exercised only on expiration.
What is a covered call options strategy?
The covered call option strategy is a method of generating income from the option premium. In covered call strategy, the trader opens a long call position and at the same time writes call options on the same asset.
Traders often adopt a covered call strategy when they believe that the asset price will not move significantly in the future market.
What is the difference between a put and a call option?
Call and put options are two instruments traded in the derivatives market. By definition, call option is a contract that gives the buyer a right, but not the obligation, to acquire an underlying equity at a decided price on or before the expiration date.
Put options, on the other hand, allow the buyer a right (but no obligation) to sell an underlying security at a pre-decided price on a said date.
How much does a call option cost?
An option contract premium is calculated using the Black-Scholes formula. It determines options premium by multiplying stock price with the cumulative standard normal probability distribution function. In the second step, the net present value of the strike price is multiplied by cumulative standard distribution and subtracted from the amount previously calculated. The formula definitely sounds intimidating, but fortunately, you can skip the trouble of doing maths, thanks to online option value calculators. There are plenty of such cost calculators available online which can calculate results really quickly and accurately.
How is call options gain calculated?
The simple way to learn whether your call option is profitable/loss is by subtracting price at breakeven from stock price at expiration. If the resultant value is positive, then the call option is profitable. Otherwise, it is a loss.
You can calculate the option breakeven price by adding options strike price with the premium paid.