Explained: What are Call Options?

Introduction:

Options trading is a popular form of derivative trading. It allows traders to take positions in the market without actually buying or selling the underlying asset. In India, options are traded on various underlying assets such as stocks, indices, currencies, and commodities.

Traders can use options to hedge their existing positions or speculate on the price movements of the underlying asset. However, options trading can be complex and risky, and it is important for traders to have a good understanding of the market before participating.

Understanding options trading in India:

The National Stock Exchange of India (NSE) and the Bombay Stock Exchange (BSE) are the two main bourses that offer stock options trading in India. The Securities and Exchange Board of India (SEBI) is the market regulator for these trading activities. Its role is to safeguard the interest of the traders and protect them against fraudulent activities. Options traders must have a trading account with a registered broker and comply with various rules and regulations in order to execute trades. In India, European options are traded, which means that they can be executed only on the expiration date of the option contract.

What is a call option?

A call option is a type of contract that gives the buyer the right, but not the obligation, to buy an underlying asset at a predetermined price (strike price), within a specific period. These assets can be stocks, commodities or currency.

The buyer of the call option expects the price of the underlying asset to rise in the future and tends to make a profit from the bullish outlook of the market.

The call option buyer pays a premium to the option seller for the right to purchase the asset at the strike price (option premium).  This premium is typically based on several factors, including the current price of the underlying asset, the strike price, the time remaining until expiration, and the volatility of the underlying asset’s price.

How call options work:

If the price of the underlying asset rises above the strike price, the buyer can exercise the call option and purchase the asset at the lower strike price and make a profit by selling it at the higher market price.

On the other hand, if the price of the underlying asset hovers below the strike price, the buyer can choose not to exercise the option, and let it expire worthless. Here, he will lose the premium paid for the option.

Example:

Let's say an investor believes that the price of a stock will rise from its current price of ₹150 per share to ₹180 per share within the next three months.

The investor can purchase a call option of the stock with a strike price of ₹160 and an expiration date of three months for a premium of ₹5.

Now, if the stock price rises to ₹180 within the next three months, the investor can exercise the call option, buy the stock at the strike price of ₹160, and sell it at the market price of ₹180, thus making a ₹15 profit in the process (180-160-5 = ₹15). There is no limit on how far above ₹160 the stock price could have gone, so the profit potential is unlimited.

However, if the stock price does not surpass the strike price of ₹160 before the option expires, then the investor can choose to not exercise the option and incur only the cost of the premium paid for the option i.e., ₹5. In this case, you should remember that no matter how low the stock price falls, the buyer’s maximum loss is only the option premium.

What are ITM and OTM call options?

A call option can be In-the-Money (ITM), At-the-Money (ATM) or Out-of-the-Money (OTM) depending upon the market price in comparison to its strike price. Simply put, here’s how they are classified:

1. ITM Call Option: Market Price > Strike Price
2. ATM Call Option: Market Price = Strike Price
3. OTM Call Option: Market Price < Strike Price

Can we understand this with a call option example?

Let’s use the above-mentioned example to understand this concept more easily:

Current Market Price: ₹150

Option Strike Price: ₹160

Expected Stock Price: ₹180

When the stock price rose and reached ₹180, the call option became ITM, as the market price crossed the call option strike price of ₹160.

If the stock price had risen but stopped at ₹160, the call option would have been ATM, as the market price would’ve been at par with the call option strike price.

Now, had the stock price remained unchanged and stayed at ₹150, the call option would have been OTM, as the market price would have been lower than the call option strike price of ₹160.

What are index call option and stock call options?

Just as stock call options give buyers the right to buy a specific stock at a specific price, index call options give buyers the right to buy an index (such as the Nifty 50 or the BSE Sensex) at a specific price. Index call options are stabler than stock call options as indices cover multiple stocks and help reduce volatility.

Here, the key difference is that index call options are settled in cash as indices cannot be physically bought or sold. In the case of stocks, the actual exchange of stocks takes place.

What influences the price of call options?

The price of call options is influenced by various factors:

1. Underlying asset price: As the price of the underlying asset increases, the price of call options tends to increase, since you can still buy the asset at a cheaper price.
2. Time to expiration: The longer the time to expiration of the option, the higher the price of the call option. This is because stock prices of good companies tend to increase over time.
3. Strike price: As the strike price of a call option increases, the price of the option tends to decrease. This is because it reduces the gap to the increased market price and profitability reduces.
4. Volatility: As the volatility of the underlying asset increases, the price of call options tends to increase as well.
5. Interest rates: As interest rates increase, the price of call options tends to increase as well.
6. Dividends: If the underlying asset pays dividends, the price of call options decreases because the value of the asset reduces during dividend payments.
7. Market sentiment: If investors are optimistic about the market, the price of a call option increases and vice versa.

FAQs:

When should a trader buy a call option?

When the trader expects asset prices to rise.

When should you sell a call option?

When the asset price rises and the option is far from its expiry date.

What is Long Call and Short Call?

Long Call is a trading strategy that allows the option buyer the right to buy the underlying asset at a predetermined price. (Useful during a bullish outlook)

Short Call is a trading strategy that allows the option seller to sell the underlying asset at a predetermined price. (Useful during a bearish outlook)

Overall, call options can be a useful tool for investors looking to profit from a bullish market outlook, but they can also be complex and involve significant risk. Investors should carefully consider their investment goals and risk tolerance before trading options.

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