Introduction
A call option refers to a financial contract that gives the buyer the right, but not the obligation, to purchase a predetermined quantity of an underlying asset at a strike price within a specified time, known as an expiration date.
Let’s understand this with an example:
Suppose that you are bullish on a technology company, XYZ Inc., whose share price is currently trading at ₹100. You are fairly confident that the stock price will rise sharply over the next few months when several new products will be launched.
Now, buying this call option represents purchasing the right to exercise a purchase of, let’s say, 100 shares of XYZ Inc. at a price of ₹110 per share within the next three months. You will have to pay a premium of ₹5 per share on the stock, which would be ₹500 (₹5 × 100) for the purchase of the call option.
Types of call options
The two main types of call options in options trading are the long call and the short call. Let’s dive into each type and explain them with examples to clarify the concepts.
1. Long call
A long call option strategy involves buying a call option contract. The buyer (holder) of a long call expects the price of the underlying asset to rise above the strike price before or by the expiration date.
Example:
Let’s say you believe XYZ Company’s stock, currently priced at ₹1,000, will rise due to a new product launch. You buy a ₹1,000 strike price call option (at the money) for ₹50 per share (100 shares) with an expiration in three months.
Breakeven:
Strike price + Premium paid = ₹1,000 + ₹50 = ₹1,050
Profitable outcome:
If XYZ’s stock price crosses the breakeven point of ₹1,050, the option becomes profitable. For instance, if the stock hits ₹1,100, your profit would be ₹1,100 – ₹1,050 (breakeven) = ₹50 per share, resulting in a total profit of ₹5,000 for 100 shares.
Loss outcome:
If XYZ’s stock stays below ₹1,050, you could lose up to the ₹50 premium paid per share, depending on where the share price is on the expiration date. The maximum loss is ₹5,000.
2. Short call
A short call option strategy involves selling a call option contract. The seller (writer) of a short call expects the price of the underlying asset to remain below the strike price until expiration.
Example:
If you believe XYZ Company’s stock, currently priced at ₹950, won’t surpass ₹1,000 anytime soon, you could sell a ₹1,000 strike call option for ₹50 per share, with an expiration in one month.
Breakeven:
Strike price + Premium received = ₹1,000 + ₹50 = ₹1,050
Profitable outcome:
If XYZ’s stock stays below ₹1,050, the option expires worthless, and you keep the premium as profit. The maximum profit is ₹50 per share.
Loss outcome:
If XYZ’s stock rises above ₹1,050, your losses could be substantial and potentially unlimited. However, you can choose to close your position before expiration to limit your losses.
Why buy a call option?
Why choose a call option over buying the stock directly? Understanding the differences between stocks and options is essential to know when to use each. Here are some common scenarios where call options stand out:
Bullish sentiment
You firmly believe a stock’s price is about to jump. A call option lets you amplify your gains compared to just buying the stock. Say the stock price skyrockets; you still get to buy it at the reduced strike price, pocketing the radical difference.
Limited capital
A call option is usually bought with less capital compared to purchasing the entire stock. By doing so, you will be able to control as many shares as you can with less capital and increase your returns whenever your predictions turn out to be right.
Hedging existing stock
You already own some stock in which you are fairly optimistic. Buying a call option is a bit like buying insurance. If the stock plummets, you can cut your losses by selling the stock and then exercising the call, thus buying back the stock at the strike price.
When to sell a call option?
Expecting a decline or stagnation in the stock price
Sell a call when you believe the price of the underlying stock is either going to drop or remain flat. By doing so, you collect the premium from selling the call, which you get to keep if the stock does not rise above the strike price.
Generating income on owned stock
Selling call options on stocks already owned can be another source of income. With something called a covered call, the premium goes directly into your pocket, and you continue to hold your shares as long as the stock price does not move above the exercise price.
Bearish on stocks you don’t own
If you believe a stock you do not own will decline or remain stable, selling a call option can allow you to profit from this expectation. You receive the premium from selling the call and hope the stock price remains below the strike price.
Call option payoff
Understanding the call option payoff is crucial. The payoff from a call option depends on the underlying asset’s price at expiration.
For the buyer
The payoff is positive if the asset price at expiration exceeds the strike price by more than the premium paid. Otherwise, the payoff is negative, limited to the premium paid.
For the seller
The payoff is limited to the premium received if the asset price stays below the strike price. If the asset price rises above the strike price, the seller’s losses can be substantial.
Call options explained: FAQs
What is call option?
A call option is a financial contract that gives the buyer the right, but not the obligation, to purchase an underlying asset at a specified strike price within a certain time frame. This section provides call options explained in simple terms.
Can anyone trade call options?
Yes, anyone with a brokerage account that offers options trading can buy or sell call options.
How much do call options cost?
The cost of a call option is called the premium, which varies based on factors like the stock price, strike price, volatility, and time until expiration.
What happens if the stock price goes down after I buy a call option?
If the stock price decreases, your call option may lose value, and you may experience a loss on your investment, up to the total premium paid.
Can I sell my call option before it expires?
Yes, you can sell your call option at any time before expiration, either for a profit if the option has gained value or for a loss if it has decreased in value.
Are call options risk-free?
No, call options involve risk. There is a risk of losing the entire premium paid for the option if the stock price does not reach or exceed the strike price by expiration.
Conclusion
In conclusion, mastering call options involves understanding market dynamics, risk management, and strategic planning. Whether used for speculation, hedging, or income generation, call options can be powerful tools in a diversified investment portfolio.
By applying the principles and examples outlined in this guide, investors can navigate the complexities of call options with confidence and potentially enhance their investment strategies.
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