Introduction
Options trading is a useful strategy to expand your market exposure without investing much money. In India, it enables investors to participate in the markets with limited risk. The two main types of options available in the derivatives market are call options and put options. If used correctly, options serve as powerful tools for building infinite wealth and hedging portfolio risks.
Generally, you execute a call option when you feel prices can increase, whereas a put option is exercised when prices are expected to decrease. Before you begin trading options, you must know their basics.
What are call options?
A call option refers to a contract between two parties wherein the buyer has the right to buy a specific underlying asset at a pre-determined price until an expiration date. Unlike futures, this contract does not oblige the buyer to execute the options contract. Thus, if the call option isn’t profitable, you can keep your losses to the minimum by allowing it to expire.
A call option can generate profits if the agreed-upon price is lower than the underlying asset’s price on the date of the execution. In trading terms, the agreed-upon price is known as the strike price. If your strike price is higher than the underlier’s price on the execution date, you will suffer a loss through the call option.
There are three types of call options:
- In-the-Money (ITM) call options
- At-the-Money (ATM) call options
- Out-of-the-Money (OTM) call options
How do call options work?
The following example sheds light on the mechanics of how call options work.
Suppose you are an Indian stock market investor. The stock price of ABC company’s share is Rs. 100. You anticipate its prospects in the future to be promising. So, you buy a call option with a strike price of Rs. 120. The premium is Rs. 7 per share, and the expiration is three months away.
Now, there are three scenarios in which you can execute your call options contract.
Scenario 1: The strike price is higher than the stock price.
If the strike price (Rs. 120) remains above the stock price (Rs. 100) until expiry, you are not obliged to exercise the option. You can let it expire worthless, limiting the loss to the premium paid (Rs. 7 per share).
Scenario 2: The strike price is lesser than the stock price.
If the stock price increases to Rs. 140, you can buy shares at the strike price (Rs. 120) by exercising the call option. Then, you can immediately sell them at the market price (Rs. 140), earning a net profit of Rs. 13 per share.
Net profit = Stock price - Strike price - Premium paid = 140 - 120 - 7 = Rs. 13
Scenario 3: The stock price is much higher than the strike price.
Call options offer leverage, allowing you to gain higher returns from significant price fluctuations. If the stock price rises to Rs. 150, your profit will be Rs. 30 per share (150-120), minus the premium paid (Rs. 7), making the net profit Rs. 23 per share.
Call options vs. put options
A put option is the opposite of a call option. A call option grants you the right to buy an underlying asset at a specified price on or before the expiration date. But a put option grants you the right to sell an underlying asset at a particular price on a specified date. The difference lies in the right to buy shares at the strike price and to sell shares at the strike price.
Conclusion
Call options are derivative contracts that provide the holder or the buyer the right, but not the obligation, to buy an underlying asset at a pre-determined price until a fixed expiry date. It is profitable to execute a call option if the market price is higher than the strike price upon expiry. The amount paid to buy the call option is known as a premium. It is based on the difference between the current price and the strike price of the underlying asset and the time left until expiry.
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