Option Basics: What is a Call Option? Call Option Explained in 8 Minutes : Option Guide

What Are Options?

In the derivative market, you can buy or sell at a specific price in the future.

Options are also a part of the derivative market.

There are two types of option one is Call Option and another is Put Option.

In this article, we will be discussing only call options.

The most detailed Definition of Call Option is mentioned below. I have taken it from Wikipedia.

A call option, often simply labeled a "call", is a financial contract between two parties, 
the buyer and the seller of this type of option.The buyer of the call option has the right, 
but not the obligation, to buy an agreed quantity of a particular commodity or financial 
instrument (the underlying) from the seller of the option at a certain time 
(the expiration date) for a certain price (the strike price). 
The seller (or "writer") is obligated to sell the commodity or financial instrument to 
the buyer if the buyer so decides. The buyer pays a fee (called a premium) for this right. 
The term "call" comes from the fact that the owner has the right to "call the stock away" 
from the seller.

In simple terms, a call option gives the holder the right, but not the obligation, to purchase the underlying stock at a specified on the day of option expiration.

A call option is basically the contract that gives the buyer right but not an obligation of buying an underlying share or index. They are just the opposite of Put Options. The put option gives you the right to sell in the future.

A simple example of a Call option is today’s price of Nifty Index is 9375 and for this underlying, if we have bought a Call option for a strike price 9500 with expiry in 60 days at a price of Rs. 10 per option.

Now on the sixtieth-day Nifty index is at 9575 and today is the day of expiry you have the right to buy the underlying which is Nifty Index at Rs. 9500.00 although the market price of the underlying is 9575.

 

What Are Call Options?

Let’s take this a little step further.

If you have not understood the above example we shall break down the example to further bits and pieces for better understanding.

When you buy a derivative call option you have the right to buy a certain amount of share or an index which is the underlying of the call option.

This is usually at a price predetermined on or before a specific date in the future expiry date.

The price which is predetermined is called the strike price.

The last date before the option will expire is called the expiry date.

Now to get this facility you have have to pay some price for the option. The price you have to pay for the option is for the option writer on the call option which undertakes the loss of risk due to a rise in the market price of the underlying beyond the strike price on or before the option contract expires.

The option writer has the obligation to sell the share to you at the strike price even if he going to make a loss on the transaction.

Hence the option writer is the ones that decide the option premium keeping in mind the options risk. At the same time, the option price is not driven by any one individual writer it is market-driven.

Now Let’s discuss the Key Aspects of the Call Option

  • The price at which you buy the Call Option is called Option Premium this amount is then passed on to the option writer. First, the amount is paid to the exchange which is then passed on to the seller.
  • Every time you call your broker To Place Order you have to mention him the specifics such as the underlying, the strike price, and the types of an option you want to buy.
  • The price which is once quoted to you by your broker and which you agree to pay for the contract is the Executed Price.
  • Once the broker places your order and which is executed the price which you have paid is Fixed and the price does not keep varying all the time.
  • Every contract the premium you have paid multiplied by the total number of shares in the option quantity is the Margin that is held by your broker.
  • Place where you can find the price of all the strike price in one place is called Option Chain.
  • The total number of people who are having an open position in option at a particular strike price and specific expiry is called Open Interest.
  • The total number of the lot since in the underlying futures and the options is all the time the same. The lot size is known by looking at Market Lot

Calling Your Broker

  • Be sure that you are Bullish on the underlying
  • Determine the price expected for the underlying to reach.
  • Select the Option Price

Agreeing To Premium

  • Understand if the Premium paid is right for the Option.
  • Use Black Scholes Option Pricing
  • Confirm the Premium

Transferring The Premium

  • Once the option contract is executed.
  • The total amount of margin amount has to be paid to the broker.
  • The broker pays to the exchange.
  • Finally, the exchange sends to the option writer.

Premium

  • The total premium is calculated by option premium paid multiplied by the market lot.
  • The market lot is the same as for the underlying.

Margin

  • Call Option the margin is the total premium paid.
  • The margin for the Right is different from that of Obligation

Options

  • Call Option for Index
  • Call Option for Stocks
  • Call Option for Forex

Hedging Tool

  • Call Option is a hedging tool.
  • It is used if you are bullish on the underlying

Aspects of Call Options

Premium

  • 30 Days to Expiry you pay a premium of Rs. 10 per option since you expect the price of the underlying to go up.
  • After a couple of days, the current premium is Rs. 20.

Option Squaring

  • Once the scope of the underlying price to go up has changed and you see a profit from the premium you have paid.
  • You can exit the call option by selling the same.
  • This affects your profit and loss.

Why Use Call Option?

  • You are bullish on an Index or Stock and expect the price to rise. But you do not have the funds to buy the stock or index.
  • It is advantageous if you want to limit your risk to only the premium paid.
  • Combining one call with another call to create SPREADS.
  • The advantage of Cost Efficiency.
  • Higher Potential returns.
  • More Strategic Alternatives.
  • Hedging.
  • Generating Income.
  • It can be used for Speculations.

Example Of Call Options

You are a trader or investor you can use a call option. A call option is a tool that can be used for speculation, hedging, and arbitrage.

Now as a trader you expect the stock market to go up in the near future. Or even certain stock you expect to go up in the near future. This is the advantage of the call option in can be done in stocks as well as index also.

Let’s discuss values for better understanding.

Assume that the Nifty is quoting at 10,000 and you are bullish about the index. You expect that the stock market could reach 11,000 in a period of 90 days.

Now you can buy 90 days to expiry call option for 10,200 or 10,300 or even 10,500.

Let’s say that Nifty Call option 90 Days to Expiry is quoting at Rs. 40.00 with a market lot of 75 units. The last traded price for the call option with Strike Price 10200 is Rs. 40 with days to expiry is 90 days. When you call your broker he confirms the price of Rs. 40 and you ask him to place the order. Once the order is placed and executed your brokers ask for total margin money for the call option.

The calculation for margin money for the Call option bought is Price per unit Rs. 40 * Total Units 75 = Rs. 3000.00.

If the index remains below 10200 which is the strike price till the contract expires you would definitely do not want to exercise your option at that price.

Now when this is clear it is important that you understand that your breakeven point would be when the Index reaches 10240. This is because you have incurred a cost of the option premium which you have paid for which is Rs. 40. This is called a breakeven point they price at which you make no profit or loss.

Now to understand the breakeven point better you have to understand the payoff chart. Now with this, we can understand that when the underlying index is between 10200 and 10240 you would be making a meager loss.

When the price of underlying reaches 10220 and your forecast for the market changes from being bullish to bearish you have the option to exercise the option.

Index being at 10220 if your expectation is positive outlook then you can hold on your option until expiry.

Now comes the Seller (Writer) of the options.

He is exactly in the opposite situation at any particular point in time you have been.

He would make a profit as long as the Underlying Index does not cross the 10240. Between 10200 and 10240 he would be losing some premium that you have paid him.

His loss is equal and in proportion to your gains. Exactly what amount you gain beyond 10240 he would lose the same amount.

For the risk the option writer has taken for the index will not go beyond 10200 he gets a premium for the same.

Furthermore, the option buyer’s margin is a lot less than that of the option seller. An option buyer has a right to exercise. Whereas the option writer has an obligation to perform.

Option buyer’s risk is limited. Option writer’s risk is unlimited. Hence the option buyer has to pay less margin money when compared to the option writer.

Example Of Stock Options

The stock that is listed on NSE or BSE all is not eligible for options trading.

There are certain criteria that allow stocks to be traded for options.

The stocks that are selected are from the top 500 companies listed in India.

Now let’s take an example for Stock Options.

Fundamentally the attributes of the call options remain the same but the way they are traded differs. Also, stock options are very different from Index options in pricing and volatility.

This is because the probability of Index with huge moves is very limited when compared to individual stock options.

Let’s take an example of TATA MOTORS. There is a budget session going on. And the stock is quoted at Rs. 1000.00 and because of the expected subsidy or any sector promotion or green energy promotion the government announces some sort of subsidy or some benefit to the sector.

Probability is high that the stock price is bullish. You do not want to buy the stock since there is a chance that the post this expectation if things do not turn positive for us than the stock can drop as. At the same time, you do not want to lose the opportunity to benefit from the bull run of the stock.

Buying futures is also risking since the underlying stock e.i. TATA MOTORS would be under tremendous pressure and highly volatile. At times when the decision is not in your favor chances are that it would lead to a loss.

Under such circumstance buying a call, an option is the best option at hand. Since the downside is limited only to the option premium paid. At the same time upside is unlimited.

RIGHT TIME TO BUY A CALL OPTION

  • Just like any other derivative timing here too is important.
  • The possible Price rise in the underlying.
  • Protect your self from paying a small premium rather than spending a lot of money to buy an entire lot of stock.
  • You have to Buy Low and Sell High.
  • Lack of movement in the underlying can lose the value of the stock option over a period of time.
  • When the outlook is Bullish.
  • One should not buy even in Neutral outlook.

RIGHT TIME TO SELL A CALL OPTION

  • Here to timing is important.
  • The possible fall in the price of underlying.
  • You have to Sell High and Buy Low.
  • Bearish Outlook.
  • Limited Earning.
  • Neutral Outlook you gain from Theta.
  • Lack of movement in the underlying would result in a gain.
  • The margin is higher. Which has to be considered while selling or writing.

How Does Margin Work In Options

Most of the time the margin calculation is very dynamic which highly depends on your broker and the volatility of the stock. Over a period of time, the change in the Market Lot size and Maring money changes for the stock.

These days most of the brokers have their margin calculator on the website for easy of doing calculations.

BUYING OPTIONS

As we have discussed earlier buying options has very limited risk. The max you can lose when you are buying options is the premium that you have paid. And hence you do not have to pay for the whole contract. While buying an option the premium paid is the only amount as margin calculated.

SELLING OPTIONS

Unlike Buying Options, Selling options carries unlimited risks. And the profits are very limited.

Hence a seller of an option has to maintain a deposit of margin with the stockbroker. And on a daily basis, the stock or the underlying price the option price movements are calculated and the amount is marked to market on a daily basis.

The exchange dictates the amount as a percentage term which has to be maintained by the broker as margin money.

If that is the case now is the right time to make necessary adjustments and save from making losses.

TRADING CALL OPTION LIKE A PRO

Nevertheless, the impact of implementing these corrections the time and other resources you spend on making these adjustments. You might not see more profit with these corrections but definitely, your capital is not going to erode.

Have you experienced this earlier? With this fundamental change have you corrected your strategy?

Would you recommend this to a newbie Option Trader?

Let’s hear your thoughts in the comments below!

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