Understanding the Call Option: The Basics of Financial Contracts
Besides trading assets like stocks and commodities, investors also indulge in derivatives trading. Derivatives trading can help with diversification, speculation, price discovery, and risk management. You might know that futures and options are the popular derivatives traded in different markets. However, very few investors understand the call option, which is essential for options trading. Let us discuss the concept in detail in this blog.
What is a Call Option?
Before delving deeper, it is essential to understand what derivatives are. They are tradable financial contracts for investors. The value of a derivative will depend on the underlying security or asset, which could be equity, commodity, or currency trading. Derivatives are primarily of two types, which are future and options. Futures are financial contracts that allow and obligate the investor to sell or buy the underlying asset at the given price and on a future date. Contrary to futures, options do not force investors to buy (call option) or sell (put option) the underlying asset at a given price and on a future date.
The buyer with a call option can purchase the underlying asset before the expiration date or choose to ignore the deal. Since options do not obligate investors to buy or sell the underlying assets, they are preferred by many over futures. The agreed-upon or predetermined price for a call is called the strike price. The expiration date of the same is usually known as the exercise date. The buyer will also pay a premium to the seller to exercise this type of option. It is crucial to note that the premium is non-refundable, even when the buyer does not purchase the underlying asset on the exercise date.
Advantages of Call Options
It allows you to purchase an underlying asset at a given strike price on a future date. You make a profit when the strike price is below the market price on the exercise date.
You can control a large position in the market by paying a small price, which is the premium.
Investors can offset losses and mitigate risks.
You have the right but not the obligation to purchase the underlying asset.
Long Vs Short Call Options
Investors must understand the differences between long and short call options. A long call option gives a buyer the right to purchase an underlying asset in the future at a strike price. On the other hand, a seller promises to sell the underlying asset in the future at a strike price in a short call option.
Long Call Option
When you purchase this, you agree to purchase an underlying asset at a strike price on a future date. However, you aren’t forced to purchase the underlying asset. It is a bullish investment strategy that allows investors to control larger positions with a small premium. When the market price of the underlying asset is more than the strike price on the exercise date, investors can purchase underlying securities and make profits. Also, you need not hold the underlying assets before the exercise date.
Many individuals sell call options to interested investors. They are allowing other investors to purchase underlying securities in the future at a given price. By selling, one can collect premiums from the buyers. It is a bearish investment strategy, as you hope the prices will remain neutral or decline on the exercise date. When the prices are neutral or decline on the exercise date, you can collect the maximum premium from buyers. Usually, individuals who own the underlying assets sell them to interested investors.
How to Calculate Call Option Payoffs?
Call option payoffs refer to the profit or loss made by trading them. As discussed above, you can either purchase or sell call options in the market. You might make a profit or experience a loss by purchasing or selling them. The payoff will depend on several factors, such as:
The market price on the expiration date
Payoffs for Call Option Buyers
Let us understand the payoff for call option buyers with an example. Let us say you invest in a call option to purchase stocks of a company at INR 50 per share. Also, you have paid a premium of INR 3 per share. On expiration, the current market price (spot price) is INR 54. Since your investment was INR 53 per share (strike price plus premium), you will make INR 1 profit on each share. When the spot price is lower than the strike price on the expiration date, you can choose not to exercise the call option. Here is the formula for calculating the payoff:
Payoff = Spot price (price on the expiration date) – strike price
Profit on Call Option = Payoff – premium
Payoff for Call Option Sellers
The payoff for sellers depends on whether the buyer is exercising the right or not. Let us say you sell a call option to sell stocks at INR 52 per share. Also, you have collected a premium of INR 1 per share. The spot price on the expiration date is INR 50, which is lower than the strike price. The buyer might not exercise their right, as the strike price is lower than the spot price. In such a case, you make a profit of INR 1 per share, which was collected as a premium. When the buyer exercises their right, you make a profit of INR 3 per share. Here’s the formula for calculating the payoff:
Payoff = Spot price (price on the exercise date) – strike price
Profit = Payoff + premium
Difference Between Call Option and Put Option
Before you indulge in options trading , it is essential to understand the dissimilarities between call and put options.
It offers the right (but no obligation) to purchase underlying assets at a strike price on a future date.
It offers the right (but no obligation) to sell underlying assets at a strike price on a future date.
Investors hope for a price increase. Even if the market price increases, they will purchase securities at the given strike price.
Investors hope for a price decrease. When the spot price is lower than the strike price, investors can make a profit.
There is no limit for profit and on how much the price of underlying assets can increase before the expiration period.
The profit is limited for put options. The price of underlying assets cannot go below INR 0.
Call options are preferred for income generation.
Put options are preferred for portfolio protection.
When Should You Buy a Call Option?
You can buy a call option when there are chances of an increase in the asset’s price. Even if the spot price is high, you will be purchasing underlying assets on the strike price, thus making a profit. If the prices of underlying securities do not increase, you don’t have to buy them on the exercise date. Investors with a bullish or optimistic outlook towards the market can invest in them.
You can invest when you want to have limited risk tolerance. When the spot price is less than the strike price, there is no obligation to purchase the securities. You will only lose the premium paid to the seller. Call options are perfect for investors who want to indulge in covered call writing, price speculation, and diversification.
When Should You Sell Call Option?
As discussed above, investors can also sell call options contracts. When investors believe that the price of underlying securities will drop in the future, they can sell call options. Even when the prices do not plummet in the future, investors will still collect the premium by selling. However, there are some risks associated with selling, which must be managed by investors.
Naked Call Option
The value of a call option will depend on an underlying asset. You can sell the contract without owning the underlying asset. It is called a naked call option and is highly risky. When the buyer decides to exercise their right on the expiration date, you will purchase the underlying asset at the current market price. Since there is no limit to upward price movement, investors might experience significant losses. Usually, large corporations indulge in naked call options, as they have a higher risk tolerance. When indulging in this, ensure that you collect a substantial premium to offset losses (if any) in the future.
A covered call option is exactly the opposite of a naked call option. Covered call options are backed by underlying securities. It means the option seller has the assets mentioned in the contract. When the buyer decides to exercise their right, the seller can provide them with the underlying assets. The seller does not purchase underlying assets from the market when the buyer decides to exercise their right. However, the option seller will depend on the current market price to make a profit. When the market price on the expiration date (spot price) is less than the strike price, the seller makes a profit. On the other hand, you can experience a loss by selling them when the spot price is more than the strike price.
In a Nutshell
Call options can help investors make profits and indulge in price speculation. Investors can either purchase or sell them, depending on their preferences. They are preferred over futures contracts, as they do not obligate the buyer to purchase underlying securities on the expiration date. Open a trading account with Religare Broking to purchase/sell call options now!