Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-10-23T18:36:31+05:30
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A call option is a financial contract based on an underlying asset, which can be stocks, commodities, or currencies. It provides the holder with the right, but not the obligation, to buy the underlying asset at a predetermined price within a specified time frame. In essence, a call option grants the holder the opportunity to purchase at a favourable price but does not require them to do so.

For instance, let's consider a call option on the stock of TCS (Tata Consultancy Services). If you have purchased a 1-month 2700 strike price call option for TCS at a cost of Rs. 45, you are acquiring the right to buy TCS shares at Rs. 2700 per share within the next month. Importantly, you are not obligated to exercise this right. If, on the settlement day, the price of TCS shares has risen to Rs. 2850, the call option would be profitable for you. However, if TCS shares are trading at Rs. 2500, you may choose not to exercise the option because it would be more cost-effective to buy the shares in the open market at the lower price of Rs. 2500. In exchange for this right without obligation, you pay a premium of Rs. 45, which represents your initial investment.
 

Understanding Indian options trading

In India, all options must be paid in cash! Why does that matter? It implies that the gains will be changed in cash on the settlement day. You cannot go to the exchange and demand that you obtain delivery of TCS shares just because you hold a TCS call option. Contracts for the near-month, middle-month, and long-month will all have call options. Remember that every call option contract has an expiration date of the last Thursday of the month.

What exactly are stock call options and index call options?

An index call option is a right to purchase an index, and the amount of profit or loss depends on how the index value changes. Because of this, there are Nifty Calls, Bank Nifty Calls, etc. Individual equities are the subject of stock options. Reliance Industries, Tata Steel, Infosys, and Adani SEZ, among other companies, are hence callable. Both scenarios use the same trading strategy for call options. When you anticipate an increase in the stock's or index's price, you purchase call options.

What exactly are an American call option and a European call option?

Let's first comprehend the idea of call option exercise before learning about European and American call options. There are two options available to you when you purchase a call option. A call option may either be exercised at the exchange or in the market by selling if you have purchased it and buying it if you have sold it. An American option can be exercised on or before the settlement date, but an European option can only be exercised on the settlement day. Stock options were historically American, whereas index options were European. Now all options have shifted to being European options only.

How do ITM and OTM call options work?

When it comes to possibilities, this categorisation is crucial. Call options that are in the money (ITM) are those whose market price is greater than their strike price. When the market price of a call option is less than the strike price, the option is said to be out of the money (OTM). If Infosys's stock price is Rs. 1000, then 980 call options are in the money and 1020 call options are out of the money.

What is time value in terms of call options?

As we previously observed, the option premium is the cost that the buyer pays to the seller in exchange for the right to purchase without being obligated to do so. There are two parts to the option premium: time value and intrinsic value. While the temporal value is the possibility that the market assigns to the option turning lucrative, the intrinsic value is the price profit. While OTM options will just have temporal value, all ITM options will also have intrinsic value.

Call Options with Example

Certainly, let's explore call options and the concepts of In The Money (ITM), At The Money (ATM), and Out of The Money (OTM) with examples.

1. In The Money (ITM) Call Option:

An In The Money (ITM) call option is one where the strike price of the option is lower than the current market price of the underlying asset. In other words, if you were to exercise an ITM call option immediately, you would make a profit.

Example of an ITM Call Option:

Suppose you purchase a call option for Company ABC with a strike price of Rs.50, and the current market price of ABC stock is Rs.60. This call option is ITM because you have the right to buy the stock at Rs.50, which is cheaper than the current market price of Rs.60. The intrinsic value of this option is Rs.60 – Rs.50 = Rs.10.

2. At The Money (ATM) Call Option:

An At The Money (ATM) call option is one where the strike price of the option is approximately equal to the current market price of the underlying asset. In this scenario, the option's intrinsic value is minimal or close to zero.

Example of an ATM Call Option:

Suppose you purchase a call option for Company XYZ with a strike price of Rs.50, and the current market price of XYZ stock is also Rs.50. This call option is ATM because the strike price is very close to the current market price. The intrinsic value of this option is negligible, and its value is primarily derived from time value and market volatility.

3. Out of The Money (OTM) Call Option:

An Out of The Money (OTM) call option is one where the strike price of the option is higher than the current market price of the underlying asset. In this case, if you were to exercise the option immediately, it would result in a loss because you'd be paying more for the asset than its current market value.

Example of an OTM Call Option:

Suppose you purchase a call option for Company PQR with a strike price of Rs.60, and the current market price of PQR stock is Rs.50. This call option is OTM because the strike price is higher than the current market price. The intrinsic value of this option is zero, as there is no immediate profit to be gained from exercising it.

Summary:

  • ITM call options have intrinsic value and can be exercised profitably.
  • ATM call options have minimal intrinsic value and derive their value from time and volatility.
  • OTM call options have no intrinsic value and would result in a loss if exercised immediately.

When trading call options, investors and traders consider the relationship between the strike price and the current market price to make informed decisions. ITM options are generally more expensive than OTM options but offer higher profit potential if the market moves in the desired direction. ATM options can provide a balance between cost and profit potential.
 

How do investors or traders use call options in different situations?

Here are various applications of Call options in different situations:

1. Speculation: Buying call options in a bullish market:

An investor can purchase calls to profit from a security's price increase if they anticipate one. The investor's overall risk while purchasing call options is capped at the option premium. The amount of money they could make is theoretically limitless. It depends on how much the market price is higher than the option's strike price as well as the number of options the investor has.

2. Speculation: Selling call options in a Bearish market:

By selling calls or taking advantage of price declines, investors can profit. The call writer's potential gain is only the option premium. 

What factors affect the call option's price?

The following are the general impacts that variables have on the pricing of an option:

1. The strike price and the underlying price:

Changes in the price of the underlying stock have a fairly direct impact on the value of calls and puts. Calls should appreciate in value when the stock price increases, since you can purchase the underlying asset for less money. 
The option's striking price, also known as the exercise price, is the set price at which to purchase or sell. The option is in-the-money if the strike price enables you to buy or sell the underlying at a price that enables you to realize a profit right away by closing out that transaction on the open market. 

2.  Time Decay:

Due to the expiration date, the effect of time is simple to grasp but requires experience to fully appreciate. Good companies typically grow over a lengthy period of time, thus time is on the stock trader's side. However, time is against the option buyer since if days go by with little to no movement in the price of the underlying, the option's value will decrease. Additionally, as the expiration date draws near, an option's value will start to decrease more quickly. On the other hand, that is advantageous for the option seller, who tries to profit from time decay, particularly in the final month when it happens most quickly.

3. Interest Rates:

The values of options are impacted by changes in interest rates, just like the prices of other financial assets. As rates rise, call options gain. When interest rates decrease, the opposite is true.

4. Volatility:

The trader must enter future volatility into option pricing models for the duration of the option. Naturally, option traders must make an educated guess by applying the pricing model "backwards" because they have no true idea what it will be. After all, the trader already knows the price at which the option is trading and, with some study, can look at additional factors like interest rates, dividends, and remaining time. Therefore, future volatility will be the only number that is absent and can be calculated from other inputs.

Traders utilize Implied Volatility to determine if an option is expensive or inexpensive. Option traders may use terms like "premium levels are high" or "premium levels are low." In actuality, they are saying if the present IV is high or low. When options are understood, a trader may decide when it is a good time to buy them because premiums are low and when it is a good time to sell them because they are high.
 

Bottom Line

  • Call options are financial contracts that grant the holder the right to purchase an underlying at a strike price at a later date.
  • When the strike price of a call option is less than the market price at expiration, it is profitable to exercise the option.
  • The market price of the call option is referred to as a premium. A call option becomes premium when the price of the underlier increases in the market. It is calculated using two factors: the difference between the underlier's spot and strike prices, and the remaining time before the option expires.
  • The primary benefit of purchasing a call option is that it magnifies stock price gains. You can benefit from a stock's gains over the strike price until the option expires for a relatively low up-front payment. Therefore, you typically anticipate the stock to increase before expiration if you are buying a call.

If you are new to options trading, then do seek professional advice. You can also check out our blogs for concepts related to Options trading. 
 

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