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 are and then let us get deeper into call options with an example.

What is a call option?

Options are financial contracts drawn on an underlying asset, which can be stocks, commodities, or currencies.

A call option is a right to buy without an obligation to buy, which means you execute an option contract when it is profitable.

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.

A call option will have a strike price, which is the specific price quoted for the underlier in the contract and expiration date. Like in the above example, the strike price of TCS shares is 2700, and the expiry date is 1-month. To purchase a  call option, you need to pay an amount to the seller/writer, called a premium. If you choose not to exercise the call option, the seller gets to retain the premium, which in that case will be his profit. If the call option holder decides to exercise the right in the contract, the seller is obligated to sell the underlier at the strike price.

The opposite of a call option is the put options. Put options give the options holder rights to sell an underlier at a strike price at a forward date. Both call options and put options trade in the Indian market. Now let’s understand options trading in India.

Key Takeaways

• Call options are financial contracts that give the holder rights to buy an underlier 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
• A call option becomes premium when the price of the underlier moves upward in the market
• The market price of the call option is called a premium. It is determined based on two factors: the difference between the spot and strike price of the underlier and the length of time until the option expires
• Call options are bought for speculations and sold for income purposes

Understanding options 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 options 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 options, 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

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.

A Guide To Call Buying Strategy

Buying call options is a good trading strategy, but it requires an understanding of buying a call option. Traders buy call options when they are bullish on an underlying because it allows them to leverage. Let’s try to understand the situation with the help of an example.

Let’s assume stocks of ABC company is selling at a spot price of RS 50. Now, you want to buy 100 shares of the company anticipating it to remain bullish. If you’re going to buy the stocks, you will have to invest RS(50*100) or Rs 5000. Or, you have the option to buy call options at Rs 300 (Rs 3*100). You can own the same number of shares by buying a call option with much less investment.

The profit potential is unlimited in both cases if the market continues to move in the current direction. But if we have to estimate the loss, it is limited to Rs 300 with the call option. But if you buy only stocks, you can lose the entire investment if the market slides. In this case, the call option functioned as a hedge against market risks.

With the call option, you can also close your position and exit trade. Continuing with the above example, if you find close to 1 month that shares are trading at Rs 55, you can sell the call options and make a profit of Rs 200. Here is how.

Price of shares Rs 55*100 = 5500 Initial Market price Rs 50*100 = 5000 Premium paid = Rs 300 Total profit = (5500-5000-300) = Rs 200

Trading calls is a useful option strategy to increase your market exposure without infusing lots of funds.

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

FAQs:

What is a Long Call Option?

A long call gives you the right to buy underlying security from an option seller at a strike price on a future date. It is an alternative to buying stocks at the spot rate, which you can also utilise to hedge against market risks.
You can profit when the stock price rises whilst avoiding the downside risks resulting from owning the stocks.

What is a Short Call Option?

It is a trading strategy where you sell a call option when you are extremely bearish about the underlier.
Let’s understand it with an example.
A trader decides to go short on the call option when he assumes stock prices to fall significantly.
Suppose the stocks of company ABC is selling at a price of Rs 100. The trader expects the price to fall, so he writes a short call at a strike price of Rs 102, and for that, he collects a premium of Rs 2 per share. He sells 100 shares and receives Rs 200 as a premium.
Let’s consider the different scenarios here.
If the stock price rises to Rs 102, the option will expire worthless.
Now suppose the stock price rises to Rs 105 in one month. In that case, the buyer will exercise the option, and the seller is obligated to sell. That comes out as a loss of Rs 3 per share for the option writer.

When Should You Buy a Call Option?

Buying a call option is a strategy when the trader is bullish on the underlying. It entitles the buyer to purchase the underlier at a strike price on a future date. However, options are rarely exercised and mostly used for speculation. Often traders will trade the options before the expiry date.
Factors that will influence the buying decision are,

• The time you want to stay in the trade
• Amount to allocate in buying the call option
• The degree by which you expect the market to make

 

When should you close a call option?

The value of the call option goes down as it approaches expiry, and it becomes less profitable. So, you must sell the call option when it is ITM or in the money. Here are three outcomes that can happen when a trader sells to close.

If the underlying asset gains significantly in the market to offset the time decay of the call option, the trader can sell to close for a profit.
When the asset price rises just enough to offset the time decay of the option, it is said to have reached breakeven. The trader exits the contracts at breakeven to close his position
The trader will sell to close to minimise losses when the underlying asset price doesn’t increase enough to offset time decay, and the value of the call option gets reduced

What are the differences between Call Option and Put Option?

Both call and put options are used extensively on various trading strategies. These options are two sides of a coin.
A call option gives traders the right, not the obligation, to buy an underlying asset at a strike price on a future date.
A put option gives the contract owner the right to sell an underlying at a pre-decided strike price on a future date. One buys a put option when he is extremely bearish on the underlying security.
In both cases, the buyer pays a premium to the option writer for owning the option.
For call options, the value of the contract increases as the asset price moves upward. But the price of a put option declines with the upward movement of the asset price.