Call Option

A call option is a financial contract that gives the buyer the right, but not the obligation, to buy an underlying asset such as a stock or index at a fixed price before a specified expiry date. Traders usually buy call options when they expect the price of the asset to rise.

Define Call Options

A call option is a financial agreement that gives the buyer the right to buy the stock or any type of underlying asset, but not the obligation, at a specified time or a specified period. A call buyer becomes profitable if the price goes above the strike price of the underlying asset.

A call option strategy gives the buyer unlimited profit potential because if the stock price goes up, they can buy at a lower price and sell at a higher price. On the other hand, a call option seller (or writer) earns a fixed premium when they sell the option, but they face the risk of unlimited loss if the stock price rises sharply.

Key Components Of a Call Option

These are some of the key components of a call option; these are almost the same for the put option, too.

• Underlying Asset: The financial product (stock, index, or commodity) on which the option contract is based.
• Strike Price: The fixed price at which the option holder can buy or sell the underlying asset.
• Expiration Date: The deadline by which the option must be exercised, or it becomes worthless.
• Premium: The amount a trader pays to buy the option contract.

In the given image, the option contract is based on Nifty50, which is the underlying asset. The strike price is 23,600, and different expiries occur every Thursday. The nearest expiry is currently trading at a premium of 22.15.

Long vs Short Call Options

An option trader can make a profit by either buying or selling call options, but their strategy should align with market conditions. Here’s a breakdown of both approaches.

Long Call Option

A trader buys a call option in the share market by paying a premium, which is one of the most common strategies used by traders and investors. The call option buyer becomes profitable if the price of the underlying asset rises above the strike price before expiry. If the asset’s price does not exceed the strike price, the trader loses the premium paid for the option.

For example, suppose Reliance is currently trading at Rs. 2500 per share. A trader buys a call option with a strike price of Rs. 2600 and an expiry date in one month, expecting the stock price to rise above Rs. 2600. 

Since one option contract represents 100 shares, the trader has the right to buy 100 shares of Reliance at Rs. 2600 anytime before expiry. If Reliance’s price goes above Rs. 2600, the trader can make a profit. If it stays below, they lose only the premium paid.

Short Call Option

In this strategy, a trader sells a call option instead of buying it and receives a premium upfront. The goal is to profit if the price of the underlying asset does not rise above the strike price before expiry. 

If the price stays below the strike price, the trader keeps the premium as income. However, if the price goes higher, the trader may have to sell the asset at a lower price, leading to potentially unlimited losses.

For example, suppose Reliance is currently trading at Rs. 2500 per share. A trader sells a call option with a strike price of Rs. 2600 and an expiry date in one month, expecting the stock price to stay below Rs. 2600. If the price remains below the strike price, the trader keeps the premium as profit. 

However, if Reliance’s price goes above Rs. 2600, the trader may have to sell the shares at Rs. 2600 while the market price is higher, leading to potential losses.

A trader should buy a call option when they expect the underlying asset to rise significantly before the option expires. This strategy works best in a bullish market outlook, where the trader anticipates sharp price movements that can increase the option’s value. Additionally, a rise in implied volatility can further boost the option’s price, making it more profitable.

Selling a call option is ideal when the market outlook is either neutral or bearish. This strategy benefits from inflated option prices due to high volatility, allowing the seller to profit if the price remains stable or declines. Additionally, option sellers gain from time decay, as the option’s value decreases as it nears expiration.

Call Options Example

Here are some practical examples to understand how call options work using real Indian stocks.

Example 1: Buying a Call Option on Tata Motors Ltd.

Suppose Tata Motors Ltd. is trading at ₹338.25 per share. A trader expects the stock price to rise over the next month and buys a call option with a strike price of ₹360 by paying a premium of ₹12 per share.

If Tata Motors Ltd. rises to ₹390 before expiry, the trader can buy the shares at ₹360 through the option contract and potentially profit from the price difference. After subtracting the premium paid, the trader benefits from the bullish price movement in the stock.

However, if the stock price stays below ₹360 until expiry, the option may expire worthless, and the trader’s maximum loss is limited to the premium paid.

Example 2: Selling a Call Option on Infosys Ltd.

Suppose Infosys Ltd. is trading near ₹1,095 per share. A trader believes the stock will remain below ₹1,150 over the next few weeks and sells a call option with a strike price of ₹1,150, receiving a premium upfront.

If Infosys Ltd. remains below ₹1,150 until expiry, the option expires worthless, and the seller keeps the premium as profit. However, if the stock price rises sharply above the strike price, the seller may face significant losses because they could be forced to sell the stock below the market price.

How do call options work?

Call options allow traders to benefit from a rise in the price of a stock or other underlying asset without buying the asset directly. A buyer pays a premium to purchase the option contract, which gives them the right to buy the asset at a predetermined strike price before the expiry date.

If the market price rises above the strike price, the value of the call option generally increases, allowing the buyer to make a profit. If the stock price does not rise as expected, the option may expire worthless, and the buyer loses only the premium paid.

Call option sellers, on the other hand, receive the premium upfront. Their goal is usually for the option to expire worthless so they can retain the premium as profit.

Trading Call Options on Stock Exchanges

Call options are actively traded on organised Stock exchange platforms such as the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). These exchanges provide a regulated environment where traders can buy and sell options contracts transparently.

Stock exchanges standardise important details like strike prices, expiry dates, and lot sizes, making options trading more structured and accessible. They also help maintain market liquidity, ensuring traders can enter or exit positions efficiently.

Why are Call Options Considered Derivatives?

A call option is classified as a Derivative (finance) because its value is derived from an underlying asset such as stocks, indices, or commodities. Instead of owning the actual asset, traders use call options to benefit from potential price movements in the market.

For example, if the price of a stock rises, the value of its call option may also increase. This relationship between the underlying asset and the option contract is what makes call options a part of the derivatives market.

Call Options as a Financial Instrument

Call options are considered a financial instrument that allows traders and investors to participate in market movements with limited upfront capital. These contracts provide the right, but not the obligation, to buy an underlying asset at a predetermined price before the expiry date.

Unlike traditional stock investing, call options offer leverage, meaning traders can potentially control a larger position with a smaller investment through the premium paid. However, the value of this financial instrument is influenced by factors such as stock price movement, volatility, and time remaining until expiry.

How to hedge with call options in a portfolio?

Investors use call options as a hedging tool to manage risk and protect their portfolios from missing out on potential upward market movements.

For example, suppose an investor has sold shares of a company temporarily but expects the stock price to rise again in the near future. Instead of immediately buying back the shares, the investor can purchase call options. If the stock price rises, the gain in the call option can help offset the higher repurchase cost of the stock.

Call options can also help investors participate in potential upside with limited capital compared to buying shares directly. Since the maximum loss for the buyer is generally limited to the premium paid, call options can provide controlled exposure to bullish market movements.

However, hedging with call options requires a proper understanding of expiry dates, strike prices, premiums, and market volatility, as incorrect positioning may still lead to losses.

Difference between Put And Call Options

Read in detail about the difference between put and call options.

Risk And Considerations Of a Call Option

Buying a call option risks losing the entire premium if the price doesn’t rise enough, while selling a call can lead to unlimited losses if the price jumps. Knowing these risks is key before trading.

• Limited Loss (Premium Paid): If the option doesn’t move in your favour, the most you can lose is the premium you paid.
• Time Decay: As the expiry date gets closer, the option loses value, especially if the stock price isn’t moving much.
• Market Volatility: Big price swings can increase or decrease the option’s value, making it harder to predict profits.

Conclusion

Call options are a way to profit from stock price movements. Buying a call can give unlimited profit if the price rises, but the risk is losing the premium if it doesn’t. Selling a call provides a fixed premium but can lead to big losses if the price jumps too much.

Factors like time decay, volatility, and market trends affect how options work. Traders should understand these risks and choose their strategy based on market conditions. With the right approach, call options can be a useful tool for earning profits while managing risks.

Frequently Asked Questions (FAQs)

How to Define a Call Option?

A call option is a derivative contract that gives the buyer the right, but not the obligation, to buy an underlying asset at a fixed price before or on a specified expiry date. Traders usually buy call options when they expect the asset price to rise.

How to buy call options for beginners?

Beginners can buy call options through a trading account that supports derivatives trading. They should first select the underlying stock or index, choose a strike price and expiry date, and then pay the required premium to purchase the option contract.

How to calculate a call option?

Profit from a call option is generally calculated by subtracting the strike price and premium paid from the market price of the underlying asset.

Call Option formula:

If the result is positive, the trader makes a profit. If not, the loss is usually limited to the premium paid.

How to use technical analysis with call options?

Traders use technical analysis with call options by studying price charts, support and resistance levels, moving averages, trend lines, and indicators like RSI or MACD. These tools help identify bullish trends and potential entry points for buying call options.

What is a call option vs a put option?

A call option gives the buyer the right to buy a stock at a fixed price before a certain date. People buy call options when they think the stock price will go up. A put option gives the buyer the right to sell a stock at a fixed price before a certain date. People buy options when they think the stock price will go down.

Can you sell a call option before expiration?

Yes, traders can sell a call option before its expiration date. If the option’s value increases due to a rise in the underlying asset price, the trader can sell the option contract in the market and book profits without waiting for expiry.

Are call options a good investment?

Call options can be a good investment if you expect the stock price to rise and want to make a profit with a smaller upfront cost. However, they are risky because if the price doesn’t go up, you can lose all the money you paid for the option. They work best when used wisely with good market research.