Trading in options derivatives is one of the most sought-after trading alternatives. It is highly remunerative but risky at the same time. You can either buy a call options contract or put options contract as per their strategy and market sentiments to generate maximum returns.
Read on to understand what a call options contract is and how it works.
Options are contracts that give buyers and sellers the right to buy or sell the underlying asset at a predetermined price on or before an expiration date. However, he/she is not obliged to go ahead with the purchase.
The two primary types of options available for trading – call options and put options. The former lets the buyer purchase an underlying security at a fixed price, while the latter gives the sellers the right to sell.
This type of options contract involves two parties – the buyer and the seller. Individuals buying call options have a right to exercise the purchase of the underlying asset at a specific price on a stipulated date. However, they are not obliged to execute the trade.
If a buyer of call options exercises their right to buy a stock, then the seller of the same has no option but to sell it. Traders generally opt for a call option when they sense that market trends are bullish and the price of an underlying asset is expected to soar. If traders choose not to go ahead with a purchase, they will lose out on the premium amount paid for the contract.
In India, the options segment in the stock market is regulated by the Securities and Exchange Board of India (SEBI). Only the stocks of the top 500 companies are allowed for options trading as per SEBI guidelines. Therefore, a stock call option allows the buyer to purchase options of certain stocks in the shares market.
Let’s understand how stock call options work. Rahul wants to buy call options of Tata Steel stock, which is currently trading at Rs.650. Now, he decides on the strike price of the contract at Rs.670 because he is expecting Tata Steel to announce robust quarterly earnings.
He purchases the call option at a premium amount of Rs.10,000. If the price of Tata Steel on or before the expiry date breaches the strike price, he can exercise his contract and earn profits. However, if earnings are not as expected and the stock price falls below Rs.650, he will allow the contract to lapse, thereby incurring a loss of Rs.10,000, which was the premium amount.
Enumerated below are the primary types of call options that traders should familiarise themselves with before starting to trade:
This is a type of call option in which the buyer has the right to purchase an underlying asset at a given price and on or before the stipulated date.
Traders opt for long call options in anticipation of rising share prices. If they believe that the price of shares of a particular company will increase due to some noteworthy events, they purchase a long call options contract. If the stock price does rise as expected, traders earn a significant amount of profit.
On the other hand, if their calculations fail and the stock price starts falling, then traders have to incur some losses. But the good thing is that their losses are limited up to the premium paid for the contract.
An investor or seller buys short call options if he/she thinks that the price of an underlying stock will fall in future. This is a contract between a writer (seller) and a holder (buyer) of an options contract.
If the stock price of the underlying asset goes below the strike price before or on the expiration date, then the call options will be worthless to the holder, and he/she will not be able to buy the stocks. Hence, the seller won’t have to sell the stocks while also getting to keep the premium amount.
The parameters that affect the price of call options are as follows:
Price of the underlying stock
One of the most important factors that determine the price of call options is the current price of the underlying asset. In case the value of underlying stocks is rising, then call options will also see an appreciation in their value. However, if underlying assets are suffering from a fall in their value, then the call options price will also decline.
Intrinsic value of the contract
This is the value of an options contract on the day the buyer decides to exercise it. One can compute the intrinsic value as the difference between the actual value of the underlying stock and the strike price. This helps an individual assess the profitability of contracts.
Another important factor that influences the price of an options contract is the time left for its expiry. Every option comes with an expiry date; the longer the expiration date, the higher the premium amount of the contract. A long expiration date offers the trader an ample amount of time before he/she has to exercise their call options.
Volatility is turbulence in the price of stocks associated with options contracts. Call options with higher volatility come with a high premium amount. This is because the more turbulent a stock is, the greater the chances of earning substantial returns. On the other hand, options whose underlying asset faces less volatility in terms of price will have a low premium amount.
The dividends announced by companies also play a role in determining call options prices. As per SEBI’s guidelines, if the dividend amount is more than 10% of the spot price of that stock, the strike price of the options gets adjusted as per the dividend amount. Any dividend announced reduces the value of the call options contract as the company was less valuable on an ex-dividends date.
You may consider buying a call option when you are optimistic about the markets being bullish in the future. If you are expecting a sharp upside in prices of underlying stocks due to their improved performance and a favourable macroeconomic or global condition, then buying call options might be a wise decision.
A seller of call options exercises this strategy when he/she foresees a fall in the price of the underlying asset. They can earn profits equivalent to the premium paid by buyers for selling their options. Therefore, one should consider selling call options when the price of the underlying security falls or remains flat.
Some differences between call and put options are as follows:
|A call option is a contract that gives buyers of these options the right, but not an obligation, to buy the underlying securities at a predetermined price on or before the expiry date.
|A put option gives sellers of these contracts the right, but not the obligation, to sell the underlying securities at a prefixed price.
|Movement of Prices
|These will earn profits only when the price of underlying stocks rises.
|These will earn profits when the price of underlying stocks falls.
|A call option has scope for lucrative gains, at least mathematically, because the price of a stock can rise exponentially.
|A put option has limited return potential. This is because the stock price can fall but can never be zero.
Call options give the right to the buyer to purchase the underlying assets at a predetermined price and book profits. However, one should closely study the prevailing sentiments of the markets before he/she starts trading in call options.
Ans: A premium is an amount that individuals pay when buying a call or put options. Paying the premium offers a trader the right to buy or sell options contracts of the underlying assets at a fixed price; however, they are not obligated to finish the transaction.
Ans: An index call option is a contract that derives its value from an underlying benchmark index like Nifty 50 or Sensex or Bank Nifty. These contracts are influenced by movements in the value of their underlying index. Traders use the increasing value of an index to earn profits from call options.
Ans: When the present value of a call options contract is higher than its pre-decided strike price, it is referred to as in-the-money (ITM) call options. On the other hand, when the current trading price of call options is lower than the pre-determined strike price, it’s called OTM or out-of-the-money call options.
Ans: A call option comes in three trading cycles. These are 1 month, 2 months and 3 months and the expiration date of each of these is the last Thursday of their respective months. In case Thursday is a holiday, contracts are settled on the last Wednesday of the month.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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