What are the Basics of Call Options?

What Are Options?

Options are contracts that grant the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified timeframe.

Basics Of Call Options

A call option provides the purchaser with the opportunity, but not the obligation, to buy the underlying asset at a predetermined price, termed the strike price, within a specified duration, referred to as the expiration date.

The underlying asset may encompass stocks, bonds, or alternative securities.The exercise price is the date by which the right can be exercised, and the premium is the fee paid for the option.

Call Option Example

Let's illustrate the concept of a call option with an example:

 

Buy Call Option Example - Suppose the shares of Gammon India are currently priced at Rs. 100 per share. Investor B owns 100 shares and wants to potentially earn additional income beyond dividends. It's expected that the stock price won't exceed Rs. 120 in the next month. After exploring call options, B finds a call option with a strike price of Rs. 120, trading at 40 paise per contract. B decides to sell one call option and receives Rs. 40 as the premium (40 paise x 100 shares).

 

If the stock price rises above Rs. 120, the buyer of the option will exercise their right to buy. B will then have to sell the shares at Rs. 120 per share. However, if the price doesn't go beyond Rs. 120, B will retain ownership of the shares and won't execute any sale.

When Should You Buy a Call Option?

When an investor buys a call option, they stand to profit if the security's price increases before the option's exercise date. If the security's value rises, the investor can buy it at the strike price and immediately sell it at a higher market price. Alternatively, they may wait to see if the price continues to rise further.

 

However, if the security price fails to rise above the strike price, the investor will only lose the premium paid for the option. This remains true even if the security's price drops to zero.

 

Exercising a call option results in profit for the investor, calculated as the difference between the security's proceeds and the strike price, premium, and any associated fees.

 

Buying a call option offers more leverage compared to purchasing the security outright. In the event of a price increase, the investor stands to gain significantly more than if they had simply sold the security.

 

Even in the scenario where the security's price plunges, the investor's loss is limited to the premium paid for the option. This caps potential losses and can lead to higher returns on a smaller investment. Additionally, the investor can sell options as the security's price rises, allowing them to profit without needing to purchase the securities themselves.

When Should You Sell Call Option?

An investor may choose to sell a call option if they anticipate a potential decline in the price of assets. Selling the option allows the investor to recover the premium even if the asset's price falls below the strike price.

 

There are two methods for selling call options: naked call options and covered call options.

• Naked Call Option:

In this scenario, the seller sells the option without owning the underlying asset. This approach carries significant risk because if the buyer exercises the option, the seller must purchase the asset at the market price to fulfill the order.

Sellers of naked call options face substantial risk as there is no limit to how high the asset's price can go, potentially resulting in significant losses. Sellers typically charge a fee to offset this risk.

Naked call options are commonly utilized by large corporations that can effectively diversify their risks.

 

• Covered Call Option:

In this case, the option is backed by an underlying asset that the seller already owns. By selling this option, the seller earns a risk-free profit from the premium charged for the call option. However, if the price of the asset experiences a sharp increase, the seller does not benefit. In this scenario, the seller cannot sell the option at a higher price; it can only be sold at the strike price.

Difference Between Call Option and Put Option

A call option and a put option are fundamentally different.

 

A call option grants the holder the right to buy an underlying stock at a predetermined price until the option expires. Conversely, a put option provides the holder with the right to sell the underlying share at a predetermined price until a specified expiry date.

 

When an investor purchases a call option, they have the right, but not the obligation, to purchase shares at the strike price either before or on the expiry date. On the other hand, when an investor buys a put option, they have the right, but not the obligation, to sell shares at the strike price.

Frequently Asked Questions

1.  When is it appropriate to buy a call option?

Investors often consider buying call options when they hold an optimistic outlook on a specific stock or security. Call options offer investors the opportunity to leverage their positions. Unlike investing directly in stocks, where the entire investment value can be lost if the stock price drops to zero, call options provide a way to limit the maximum potential loss an investor may face.

 

2. When should I sell a call option?

Sell a call option when you expect the stock's potential gains to be limited. For example, if you're comfortable with the stock staying below the strike price, selling a call option can generate income through the premium received, regardless of whether the stock rises or falls.

 

3. How do call options function?

A call option is a contract where a buyer and a seller agree on buying a particular stock at a set price until a specified expiry date. The buyer of the call option holds the right, but not the obligation, to exercise the option and purchase the stocks.

 

4. What is a call option, and could you provide an example?

A call option gives the holder the right to purchase a stock, whereas a put option grants the holder the right to sell a stock.

Think of a call option like a deposit for a future purchase. It's important to note that options carry risks and may not be suitable for all investors. Options trading is speculative and involves a high risk of loss.

 

5. Is purchasing a call option considered bullish or bearish?

Buying calls is bullish because the buyer profits only if the share price rises. On the flip side, selling call options is considered bearish because the seller earns a profit if the share price fails to increase.