A call option is a contract wherein the buyer is vested with the right to purchase the underlying asset at a predetermined price within the stipulated expiration date. The underlying real asset for call option amounts to bond, stock, or any other form of security.
Few terms associated with the option have been mentioned below.
Call Option Example
Assume that Gammon India stocks are at Rs. 100 for each share. B, an investor, holds 100 such shares and seeks to generate income beyond the dividend. The stocks are not expected to increase beyond Rs. 120 in the next month.
B assesses call options to find that a call trading of Rs. 120 exists at 40p each contract. The investor sells one call option and receives Rs. 40 as premium (40p X 100 shares).
If the shares’ price rises beyond Rs. 120, a buyer of the option will exercise the right. B will have to deliver the shares at Rs. 120 per share. However, if the price does not increase beyond Rs. 120, B will hold on to the shares and not affect any sale.
A long call is the most prevalent stock call option strategy employed by investors while buying an option. It focuses on an underlying asset’s market price to increase substantially beyond the strike price before the expiration date.
Investors have to pay a premium for buying a long call option. In the case of speculation about an increase in share prices, investors buy these options due to the possibility of improved profits. However, if the price drops below the strike price, option holders stand to lose the amount paid for option agreement as well as premium.
For example, let’s assume stock ABC has a price per share of Rs. 50. X buys one call option of Rs. 55 for ABC as the strike price and expiration date in one month. It is anticipated that its price will increase to Rs. 55 in the following month. X, being the holder of a call option, retains his/her right to purchase 100 shares of ABC at Rs. 55 till the expiration date. In this case, one option would amount to 100 shares of ABC.
Assuming that the premium is Rs. 2 per share, a buyer has to pay Rs. 200 to an options writer. This amount is the maximum that a buyer will agree to suffer as a loss. If the price of ABC eventually increases to Rs. 60 in the following month, the buyer exercising this call option can buy 100 shares at Rs. 55 and sell those immediately at Rs. 60 in the market. It leads to a profit of Rs. 5 for each share. If ABC’s price does not increase beyond the strike price of Rs. 55, then the option expires after the stipulated date. The buyer thus also incurs a loss of Rs. 200 on the premium.
Short call option involves selling an option when an investor has to purchase a given underlying asset at a predetermined price. A short call strategy leads to limited profit if shares are traded below the strike price, and attracts substantial risk if it is sold at a value exceeding its strike price.
Short call strategy is suitable to use when an underlying asset is anticipated to experience a moderate fall. This strategy will help in generating upfront credit that may be effective in offsetting the margin.
For example, stock ABC has a price per share of Rs. 50. X, an investor, anticipates its price to fall by the following month. X writes one call option with Rs.53 as strike price having expiration date in a month. The seller will thus receive a premium of Rs. 2 per share amounting to Rs. 200. If ABC does not surpass Rs. 53, this option expires, and the option writer gains Rs. 200. If its price increases to Rs. 55 within a month, the call option will be considered to have been exercised. Its option writer will have to sell his/her shares at Rs. 53 as opposed to Rs. 55. It would result in a loss of Rs. 2 for each share for that option writer.
An investor buys a put option when there is an anticipation of the price of an underlying asset to fall within a stipulated period. In the case of a put option, buyers retain the right to sell an underlying asset at a predetermined price until its date of expiration.
To exercise this right, a put buyer has to pay a premium. When the price of an underlying asset decreases below the strike price, the put option acquires an intrinsic value. It is then that a buyer can sell this option for a profit or sell at its expiration date. Check out a few basic differences between the two options.
|Call Option||Put Option|
|It offers a right to buy an underlying asset at a pre-determined strike price on a particular date, without any obligation.||It offers a right to sell an underlying asset at a pre-determined strike price on a particular date, without any obligation.|
|Investors anticipate an increase in price.||Investors anticipate fall in price.|
|Profit is unrestricted since there is no ceiling to price rise.||Limited profit as price decreases will eventually be arrested at zero.|
If a security’s price increases before its exercise date, buying a call option may yield a profit to an investor. If there is indeed a rise in the value of a security, it should be bought at the strike price, and immediately sold off at a higher market price. Holder of call options may also wait a little longer to discern a possibility of further price rise.
Such an option is not exercised if the price of securities fails to rise above the striking price. In such a situation, the investor will only suffer a loss of premium. This approach holds true even if the price of securities drops to zero.
In exercising a call option, profit or intrinsic value accruing to investors is the remainder of security proceeds after deducting the striking price, call option premium and any associated transactional fees.
Buying a call option can be more lucrative than purchasing security because the former provides more leverage to the holder. In the case of price rise, a holder stands to make substantial gains as opposed to only selling the security. Even if the price of securities plummets, an investor will only lose a fixed amount. It would restrict any further loss that an investor may otherwise incur. It leads to a generation of higher return even for a lower investment. The investor may also sell off options with an increase in securities’ price. It enables the investor to make a profit without even having to pay for securities.
An investor should sell a call option if there is a reason to believe that the price of assets may plummet. The premium amount can still be recovered if the asset’s price drops below the strike price.
There are two ways by which call options can be sold – naked call option and covered call option.
In this case, the holder sells the option in the absence of the involved asset’s ownership. It includes a significantly high risk because if a buyer decides to exercise an option, the seller will have to purchase the asset at market price to meet the order. Sellers of the call option are exposed to enormous risk as there is no limit to an asset’s price, which may result in substantial loss. A seller thus usually charges such a fee that may offset its risk involved.
Naked call options are usually exercised by big corporations which can successfully diversify the risks.
In this case, an option is covered by an underlying asset. The seller already owns his/her asset, and on selling this option, makes a risk-free profit from the premium charged for a call option. However, the seller does not benefit if the price of an asset experiences a sharp increase. Here, the holder cannot sell this option at an increased price. It can only be sold at the strike price.
Call option finds many advantages in providing higher cost-efficiency and is also available as a less risky investment avenue as compared to equities. It thus offers a strategic alternative to investors, delivering greater returns along with risk diversification.