Introduction

If you're interested in learning more about the investment world of options, you should first learn what a call option means. In the frame of reference of the Indian financial market, a call option is a derivative that offers risk income and, in the simplest of terms, provides you, as an investor, a profit on only the movement of the price of an underlying asset without owning it. In this article, we will explain a call option and provide more information to enhance your overall investment experience in India.

What Is a Call Option?

A call option is a financial contract that provides the owner the right, but not the obligation, to buy the underlying asset (stock, index, or commodity) at a fixed price (strike price) before or on the expiry date of the option. To have this right, the owner of the call option pays a premium. The owner assumes that the underlying asset's price will increase by more than the strike price to make a profit, which is calculated by the difference between the underlying asset's price and the strike price. An example of a call option traded in equity markets in India includes stocks and index instruments like the Nifty 50, which trade on exchanges like the NSE.

For instance, if you believe that a company's stock should rise, a call option allows you to profit from the stock price increase in a much safer manner for a limited upfront investment relative to acquiring the stock at a greater cost. If you are incorrect in your expectations, your loss is always limited to the premium paid, making this strategy a defined-risk strategy.

What you need to know about call options:

Strike Price: The price agreed in advance to purchase the asset.

Premium: The cost you pay to purchase the option itself, influenced by market factors such as volatility and time until expiry.

Expiry Date: The latest date or deadline to use your option or let it "expire."

Underlying Asset: This asset could be a stock, an index such as Bank Nifty, or another asset.

Potential Profits: If the asset's value increases above the strike price, you can buy at the lower price and sell at the market price, pocketing the difference (netting out the premium).

Limited Losses: If the price remains below the strike price, you do not use your option and lose only the premium.

Call Option Example

Think of a stock (XYZ Ltd.) trading at ₹200 per share. You think it will rise to ₹230 over the next month. You purchase a call option on the stock - strike price of ₹210, and you pay a ₹ 5 premium per share for 100 shares (purchasing the option costs ₹500). If XYZ rises to ₹230, you exercise the option (you are buying 100 shares of XYZ traded at ₹210) and sell 100 shares XZY at ₹230 on the market; you have earned ₹20 per share (total ₹2000 earned) and you have to give up the ₹500 premium you paid, therefore your net profit is ₹1500. If XYZ does not rally and stays under ₹210, the option will expire worthless, and your loss would be limited to the ₹500 premium.

Call option and put option difference

When to Consider Buying Call Options

Since you are optimistic about the stock or index you are trading, which you believe will increase significantly in value before the option expires, you might buy a call option. Call options offer a way to gain leverage, meaning potential returns can be amplified in relation to the premium invested, compared to simply buying the stock. A slight increase in the stock price can lead to a significant increase in the premium because options are leveraged and sensitive (or have a high delta) to movements in price.

When to Consider Selling Call Options

Selling a call option is a good decision if you expect the underlying price to be flat or possibly to decrease slightly over time. Selling a call option is especially true if you sell a covered call (you own the underlying stock). As you sell the call option, you will not lose anything except for the premium income you receive. If the price of the underlying asset moves higher, you could incur a loss if you sold a naked call (you do not own the underlying stock for that call).

Conclusion

Call options can be a versatile way to capitalise on certain market moves in India's volatile financial services market. Whether you're looking to buy options to create larger upside from the underlying asset or you want to sell options to earn premium as income, understanding what a call option in stocks means to you, return, risk, and difference from put options can help you make good decisions as you become involved in call options. If you need assistance navigating whichever choice you have decided on, Motilal Oswal can assist you with whichever strategy aligns with your interests.

Also explore: How does buying and selling call options work? | Call vs. Put Options - What are they and how do they work? | How do I use Call and Put options?