Buying Call Options: Everything to Know

Call options are a fundamental component of options trading strategies, allowing traders to profit
from price movements in various financial derivatives. By understanding the concept of buying call
options, investors gain a powerful tool to potentially increase their returns and manage risk
effectively. This guide will dive deeper, exploring their mechanics, benefits, and strategies to
empower you in your trading journey.

What are Buying Call Options?

Buying call options is a strategy where an investor pays a premium for the right to purchase a
specific asset at a predetermined price within a set time. It’s a bet that the asset’s price will
rise, allowing the investor to buy at a lower agreed-upon price (strike price) and potentially
profit. If the price doesn’t rise, the investor is only out the premium paid for the option

A call option
gives the buyer the right to purchase an asset at a predetermined price by expiration. Buying calls
involves paying a premium, which is the price of the option, to the seller or writer.

When investors buy a call option, they acquire the right to buy the underlying asset at the strike
price, regardless of its current market price. This allows the buyer to profit from upward price
movements in the underlying asset. Note that the call option buyer is not obligated to exercise
their right to buy the asset.

The key terms to understand when buying call options include:

• The strike price is the agreed-upon price at which the underlying asset
  will be bought.

• The expiration date is when the option must be exercised or it becomes void.

• The premium is the cost of the option.

As the buyer of a call option, you have the right to decide whether or not to exercise the option.
If the market price of the underlying asset is higher than the strike price at expiration, it may be
advantageous to exercise the option and buy the asset at the predetermined price. On the other hand,
if the market price is lower or the option has not reached its profit potential, you can choose not
to exercise the option and limit your losses to the option premiums paid.

Buying Call Options Explanation

When buying call options, clearly understand how they work within the broader context of investment
strategies. Call options can be used in various ways, depending on an investor’s goals and market
conditions.

One common strategy involving call options is known as speculation. In this approach, investors
purchase call options on stocks they believe will experience a significant price increase in the
future.

By buying the call option, investors can profit from the stock’s price appreciation without
committing a large amount of capital upfront. This strategy can be particularly attractive when
market conditions are favourable and there is an expectation of a bullish trend in the underlying
asset. Another strategy involving call options is called hedging. Hedging allows investors to
protect their existing positions in the market. For example, if an investor holds a substantial
amount of a particular stock, they may purchase call options to safeguard against potential price
declines. If the stock’s price indeed falls, the investor can exercise the call options to limit
their losses or potentially offset them with the profits from the options.

Market conditions play a crucial role in call option buying decisions. When the market is volatile
or uncertain, investors may be more inclined to purchase call options to manage risk. Call options
can provide leverage, allowing investors to magnify their gains if the market moves in their favour.
However, assess market conditions, analyse the underlying asset’s performance, and consider the
potential risks before buying call options.

Example of Buying Call Options

In a hypothetical scenario, let’s consider a trader who is monitoring the Indian
stock market and observes that a popular technology company, ABC Ltd., is about to release
a highly anticipated product. The trader anticipates that this release will result in a significant
increase in the stock price of ABC Ltd. The trader decides to employ a call option strategy to
capitalise on this potential opportunity.

The trader purchases a call option contract for ABC Ltd., with a strike price of Rs 500 and an
expiration date of one month. The option premiums paid for the call option is Rs 10 per share, and
each option contract represents 100 shares.

By purchasing the call option, the trader has the right, but not the obligation, to buy 100 shares
of ABC Ltd. at Rs 500 per share within the specified time frame. If the stock price of ABC Ltd.
exceeds Rs 500 at expiration, the trader can exercise the option and buy the shares at the strike
price, benefiting from the price difference. However, if the stock price remains below Rs 500, the
trader can choose not to exercise the option and limit their loss to the premium paid.

In this example, let’s assume that the anticipated product release promptly leads to a surge in the
stock price of ABC Ltd. to Rs 600 per share before the option’s expiration.

Recommended Read: Future & Options in India

The trader can now exercise the call option, purchasing 100 shares of ABC Ltd. at Rs 500 per share
despite the current market price of Rs 600. The trader can either sell these shares at the current
market price, realising a profit of Rs 100 per share or hold onto the shares for further potential
gains.

Buying call options Advantages

Buying call options offers several advantages for traders regarding options trading strategies and
financial derivatives. Firstly, call options provide leverage, allowing traders to control a larger
position of an underlying asset with a smaller investment. By paying only the premium for the
option, traders can amplify their profits if the price of the underlying asset rises. This leverage
can be particularly attractive to them seeking higher returns on investment.

Secondly, buying call options offers flexibility. Traders can choose their desired strike price and
expiration date, tailoring their options contracts to market expectations and investment goals. This
flexibility enables traders to adapt their strategies to different market conditions and capitalise
on short-term price movements or long-term trends.

Further, buying call options limits the trader’s risk exposure. Unlike purchasing the underlying
asset directly, the risk is limited to the premium paid for the option. This predetermined risk
allows traders to protect their capital and define their potential losses in advance. Buying call
options advantages include the potential for significant profits if the underlying asset’s price
rises, leveraging capital efficiently, and benefiting from price movements without owning the asset
outright

Buying call options Strategies

Buying call options offers several strategies that traders can employ in options trading . One
approach is buying in-the-money calls, where the strike price of the option is lower than the
current price of the underlying asset.

This strategy gives traders a higher probability of the option being profitable, as it already has
intrinsic value. In contrast, buying out-of-the-money calls involves selecting a strike price higher
than the current price of the underlying asset. This strategy is more speculative, as it relies on
the underlying asset’s price to increase significantly for the option to become profitable.

Furthermore, call options can be used for speculative purposes. Traders may buy calls on stocks or
other assets they believe will experience substantial price increases. This allows them to profit
from the upward movement without investing much capital.

On the other hand, call options can also be used as a hedge against existing positions. By
purchasing call options on an asset they own, traders can protect themselves against potential
downside risk. If the price of the underlying asset declines, the losses on the asset can be
partially offset by the gains from the call options.

Moreover, traders can combine call options with other options or assets to create more complex
strategies. One popular combination is a call spread, where a trader simultaneously buys a call
option and sells a call option with a higher strike price. This strategy allows traders to reduce
the cost of buying the call option while capping their potential profits.

Risks of Buying call options

Buying call options can be an attractive strategy in options trading. Still, it is important to be
aware of the risks involved.

One significant risk is the possibility of a total loss of the premium paid. Unlike stocks, options
have a limited lifespan and can expire worthless if the underlying asset’s price does not reach or
exceed the strike price by the expiration date. This means that if the anticipated price movement
does not occur within the specified time frame, the option buyer can lose the entire premium paid
for the option.

Another risk associated with buying calls is time decay. As the expiration date approaches, the time
value of the option decreases. This means that even if the underlying asset’s price moves in the
desired direction, the option’s value may not increase as expected due to the diminishing time
value. Traders need to be mindful of this risk and consider the timing of their trades to maximise
the profit potential.

Market volatility is also a factor to consider when buying calls. Higher volatility can increase the
cost of options, making it more expensive to enter into trades. Additionally, sudden and significant
price fluctuations can impact the option’s value, leading to potential losses. Traders should
carefully assess market conditions and volatility levels before executing their options trades.

Buying call options can be a viable strategy for options trading, but it is crucial to understand
the risks involved. The potential for total loss of the premium paid and the impact of time decay
are important considerations when engaging in this financial derivative. To mitigate these risks,
traders should carefully analyse market volatility, select appropriate strike prices and expiration
dates, and incorporate risk management strategies into their trading plans.