Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-09-14T11:03:17+05:30

Introduction

Options trading is one of the most widely used types of derivatives trading. It provides the contract buyer with a right to buy or sell, as per the type of options contract. A call option gives the contract buyer the right to buy whereas a put option means the contract buyer possesses the right to sell. In this article, we will dig deep into what is a call option.

Understanding Call Options

The type of options contract that gives its buyer the right to buy an underlying at a predetermined price, at a future date is known as the call option. The call buyer pays an amount called a premium, which the call seller receives. Unlike stocks, which can last forever, options cease to exist when they expire and either become worthless or have some value. The most defining traits of an options contract include:

Strike price: This is the predetermined price at which the contract buyer can buy the underlying asset
Premium: This is the price a contract buyer pays to avail of the rights
Expiration: It is an event when the option expires, and settles.

How does a call option work?

Call options are “in the money” if the stock price is above the strike price at expiration. Call holders may exercise their options by contributing cash to purchase the shares at the strike price. Alternatively, the option owner can simply sell the option to another buyer at the fair market price before the option expires.

Call options pay off when the premium paid is less than the difference between the underlying assets’ price and the strike price at expiration.

For example, suppose a trader bought a call for INR 0.50 with a strike price of INR 20, and the stock price is INR 23 at expiration. The option is worth INR 3 (the INR 23 stock price minus the INR 20 strike price) and the trader has made a profit of INR 2.50 (INR 3 minus the premium of INR 0.50).

If the stock price is below the strike price at expiration, the call is out of the money (OTM) and expires at no value. The call seller retains the premium received for the option.

Types of Call Options

There are only two types of call options that are simply based on the position you take in an options contract:

Long:

A long call option means that an investor is buying the call option. Here the investor gets a right, and not an obligation to buy the underlying asset. An investor usually goes long on an asset when he thinks that the security has the potential to go up above its current level. Therefore, the investor locks in the prices at current levels to benefit from a price rise in the future.


Short:

This is an offsetting position of a call option and means that an investor is selling the contract. Shorting a call option means that the investor is receiving an obligation and not a right to sell the underlying asset. The belief behind shorting a contract could be that the security going below its current price levels. If true, the short seller of the contract benefits from the options premium.

Why buy a call option?

The most significant advantage of buying a call option is that magnifies the rise in stock prices. For a relatively small initial cost, you can enjoy the benefits of the stock above the strike price until the option expires. Therefore, when you buy a call, you typically expect the stock price to rise before it expires. 

Suppose security ABC is trading at INR 20 per share. You can buy a call on the stock with an INR 20 strike price for INR 2 with an expiration in eight months. One contract costs INR 200 (INR 2 * 1 contract * 100 shares). 

Above the strike price, the value of the option (at expiration) increases INR 100 for every one rupee increase in the stock price. As the stock moves from INR 23 to INR 24 – a gain of just 4.3 per cent – the trader’s profit increases by 100 per cent, from INR 100 to INR 200.
 
There can be an instance where the option may be in the money (ITM) at expiration, but the trader may not have made a profit. In this example, the premium cost is INR 2 per contract, so the option breaks even at INR 22 per share, the INR 20 strike price plus the INR 2 premium. Only above that level does the call buyer make money. In this instance, while there is a payoff, there is no profit.
 
If the stock finishes between INR 20 and INR 22, the call option will still have some value, but overall the trader will lose money. Below INR 20 per share, the option expires worthless and the call buyer loses the entire investment.
 
The appeal of buying calls is that it significantly increases the trader's profits compared to outright ownership of the stock. Let’s say, they have an initial investment of INR 200 and the trader can buy 10 shares or 1 call.
 
If the stock finishes at INR 24, then, 

  • The investor makes a profit of INR 40, or (10 shares * INR 4 gain).
  • The options trader makes a profit of INR 200, or the INR 400 option value (100 shares * 1 contract * INR 4 value at expiration) minus the INR 200 premium paid for the call.

 
In percentage terms, the stock returns 20 per cent while the option returns 100 per cent.

Why sell a call option?

Every time a call is bought, a call is sold. The thought process behind the transactions is the opposite. In other words, buying calls reverses the payout structure. Call sellers expect the stock price to stay flat or fall, hoping to pocket the premium with no consequences. 

Let's use the same example as before. Suppose ABC security is trading at INR 20 per share. You can sell a call of stock for INR 2 with a strike price of INR 20 over eight months. One contract gives you INR 200 (INR 2 * 1 contract * 100 shares).

The payoff schedule here would be exactly the opposite of that of the call buyer:

  • For every price below the strike price of INR 20, the option expires worthless, and the call seller gets to keep the cash premium of INR 200
  • Between INR 20 and INR 22, the call seller still benefits from the premium but not all
  • Above INR 22 per share, the call seller begins to lose money beyond the INR 200 premium received.

 
The major advantage of selling calls is that you receive a cash premium as an initial cash inflow and do not have any outflow immediately. At expiration, If the stock falls, stays flat, or even rises just a little, you’ll make money. However, you won’t be able to multiply your money in the same way as a call buyer. As a call seller, your upside is limited and the most you’ll make is the premium.
 
While selling a call seems like it’s low risk – and it often is – it can be one of the most dangerous options strategies because of the potential for uncapped losses if the stock soars. 
 
For example, if the stock doubled to INR 40 per share at expiration, the call seller would lose a net INR 1,800, or the INR 2,000 value of the option minus the INR 200 premium received. However, you can play safe with call-selling strategies, such as the covered call, that could be utilized to help protect the seller.

How to Calculate Call Option Payoffs

At expiration, the call options’ intrinsic value or payoff depends on where the underlying price is relative to the call option's strike price. Typically, payoff and profit are two different metrics.

The key determining factors include:

  • Strike price
  • Premium
  • Current underlying price

Payoff only considers the strike price and the current underlying price, irrespective of the premium. Suppose, you buy a call option worth INR 2 for a strike price of INR 20. At expiration, if the underlying price is INR 24, your payoff would be INR 4 (INR 24-20).

However, in the above example, the profit would be INR 2 (Underlying asset price - strike price - premium paid). 
 

Purposes of Call Options

There are three primary purposes of call options:

1. Income: Some investors use call options to generate income through the covered call strategies. This strategy consists of owning the underlying stock and simultaneously writing a call option or giving someone else the right to buy your stock. 

While this strategy provides investors with additional income, it can also limit profit potential if the underlying stock price rises sharply. Above, the option buyer exercises the right to purchase the shares at the lower strike price. This means that option writers do not profit from stock price movements above the strike price. The maximum profit an options writer gets from options is the premium received.


2. Speculation: Option contracts expose buyers to gain significant exposure to stocks at relatively low costs. Alone, it can generate huge profits when stock prices rise. However, the premium could also be lost 100% if call options expire worthless because the underlying stock price did not exceed the strike price. The advantage of buying a call option is that your risk is always limited to the premium paid for the option. 

Investors can also buy and sell different call options simultaneously to create a call spread. They limit both the potential gains and losses from the strategy, but in some cases, the premium earned by writing one option offsets the premium paid on the other option, so a single call is more cost-effective than options.


3. Tax Management: Investors may use options to change portfolio allocations without actually buying or selling the underlying securities. 

For example, an investor may own 100 shares of her XYZ stock and be liable for a large unrealized capital gain. To avoid the occurrence of a profitable event, shareholders can use options to de-risk the underlying security without actually selling it. In the above case, the only cost to shareholders engaging in this strategy is the cost of the option contract itself. 

Examples of Call Options

Suppose that a security is trading at INR 98 per share. You hold 100 shares of the stock and want to generate an income above and beyond the stock's dividend. You also believe that shares are unlikely to rise above INR 113 per share over the next month.

You take a look at the call options for the following month and see that there's an INR 113.00 call trading at INR 0.4 per contract. So, you sell one call option and collect the INR 40 premium (INR 0.4 x 100 shares).

If the stock rises above INR 113, the option buyer will exercise the option, and you will have to deliver the 100 shares of stock at INR 113 per share. You still generated a profit of INR 15 per share, but you will have missed out on any upside above INR 113. If the stock doesn't rise above INR 113, you keep the shares and the INR 40 in premium income.

This strategy is known as the covered call.

The Bottom Line

Call options are financial contracts that give the option purchaser the right, but not the obligation, to purchase a stock, bond, commodity, or other asset or commodity at a specified price within a specified period. Stocks, bonds, or commodities are called underlying assets.

Options are speculative instruments that rely primarily on leverage. If the price of the underlying asset rises, the call buyer can make a profit. A call option seller can earn revenue by collecting a premium from the sale of the option contract. The tax treatment of call options depends on the profit-generating strategy and the type of call option. 

FAQs:

Q.1: How does a call option work?
Ans: Call options payoff when the premium paid is less than the difference between the underlying assets’ price and the strike price at expiration.

Q.2: What are call options with examples?
Ans: The type of options contract that gives its buyer the right to buy an underlying at a pre-determined price, at a future date is known as the call option. Suppose a trader bought a call for INR 0.50 with a strike price of INR 20, and the stock price is INR 23 at expiration. The option is worth INR 3 (the INR 23 stock price minus the INR 20 strike price) and the trader has made a profit of INR 2.50 (INR 3 minus the premium of INR 0.50).

Q.3: Can you sell a call option early?
Ans: You can sell the options contract to other buyers at the prevailing market price.

Q.4: What happens if the call option expires out-of-the-money?
Ans: In case the call option expires OTM, the buyer loses the premium paid to buy the contract and the seller earns the profit.

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