If you have been learning about the stock market, you may have heard many investors label futures and options as risky assets. They are not wrong; however, it’s no secret that some of the most renowned investors, like Warren Buffett, included derivatives as part of their investing strategies. The most skilled traders and investors use derivatives in various ways, namely to diversify, hedge existing holdings, and speculate. You, too, can learn how to implement derivatives effectively to help grow your wealth. But first, it is essential to learn how these contracts work. So, in this article, we will help you understand call options. What is a call options contract? How does it work? Let’s find out.
Table of Contents
Defining a Call Option
Since options qualify as derivatives, all option contracts are pegged to an underlying asset. In other words, they derive their value from an underlying asset. This asset could be a stock, commodity, currency, or index.
A call option is a financial contract that gives the buyer of the contract the right to buy the underlying asset on a future date at a predetermined price. It’s worth reiterating that as a call option buyer, you have the right to buy the underlying asset with no obligation whatsoever. The future date is the expiry date, while the predetermined price is the strike price, the price indicating the price of a single unit of the underlying asset.
Defining Some Important Terms
- Strike Price: The strike price is a predetermined value at which the option holder can buy or sell the underlying asset when exercising the option. It serves as a reference point to determine the profitability of the option contract.
- Expiry Date: The expiry date is the specified date when a derivative contract, such as options, comes to an end. On this date, the contract is either settled or expires worthless. It is a crucial factor that influences the timing and effectiveness of trading strategies in the derivatives market.
- Lot Size: It is the number of units bound to the contract. So, when you are trading options, you may be dealing with several units of a share or asset.
- Option Premium: To buy an options contract, the buying party pays a fee called the option premium, or premium, to the option seller. The premium is not a fixed fee but a variable fee, and its value depends on several factors, including the current market price of the underlying asset, demand for the contracts, the expiration time, market volatility, etc. By paying this premium, the call holders get the privilege to demand the underlying assets upon the expiration of the contract. If they do so, they are exercising their right to purchase the assets at the agreed-upon price. However, it is not necessary to do so as there are other viable alternatives as well; let’s look at all the options a call holder has.
Working of a Call Option
Exercising the Right
If the buyer decides to move forward and exercise their right on the expiry of the contract, they purchase those assets at the strike price, regardless of whether the underlying asset is worth more or less than the strike price at the time of expiry. However, if they choose to exercise the contract, they are to buy the exact number of units as mentioned in the lot size.
Not Exercising the Right
In the scenario where the contract holder chooses not to exercise the contract, they lose the premium they paid to buy the contract. Suppose the value of the underlying asset trades below the strike price on the expiry date; the option buyer may forgo their right to exercise the option.
Closing the Position
The final alternative is to sell the contract before expiration and close or offset their positions. When a call option holder exits or offsets their position, they lose their rights to buy the shares on expiry. However, many option buyers go down this path as they aim to make profits off the premium since it continuously fluctuates in value. However, this is a very risky way to trade and make money off options.
Example of a Call Option
The call options contract we will be assessing is the Nifty Jan 18000 CE. In this case. ‘Nifty’ denotes that the underlying asset is the Nifty 50, while ‘Jan’ denotes it’s a monthly option expiring in January. ‘18000’ is the strike price, and ‘CE’ denotes that it’s a call option. If you proceed to buy this contract, you will see that one lot of Nifty options contains 50 units. The strike price and lot size vary from asset to asset.
Let us assume that you purchase the call by paying a premium of ₹9,000 in the first week of January. On the expiry, which is the last Thursday of the month, the Nifty is trading at ₹18,800. So, in this case, your profit is:
Profit = 18,500 (50) – [18,000 (50) + 9,000] = 9,40,000 – (9,00,000 + 9,000) = ₹31,000 (expenses excluded).
However, at the same time, in the third week of January, the value of the Nifty was around ₹18,700. Now, the premium for the contract you hold, which is Nifty Jan 18000 CE, trades at ₹15,000. So, if you wish, you can consider closing your position and taking a profit of ₹6,000 home.
Don’t forget that you can buy multiple lots.
To summarise, as an options buyer, you can make profits if the price of the underlying assets appreciates above your strike price. Use our options price calculator to easily calculate your option prices, breakeven points, and risk.
Long Call Option Vs Short Call Option
- A long call option is what we have covered so far—buying a call option by paying the premium and getting the right to purchase the underlying securities once the contract expires.
- Short call options entail selling a call contract to a buyer by charging a fee, i.e., the premium. So, in the case of short call options, the seller, also called the writer, sells a contract to the buyer in exchange for the premium. By doing so, they oblige themselves to sell the underlying assets if the buyer decides to exercise the option.
Becoming an options writer to execute the short-call strategy requires more capital since you must maintain a certain deposit with your broker. At the same time, it involves unlimited risks because the downside is endless, which is why it is less popular in the retail segment.
Understanding ITM, ATM, and OTM Call Options
Based on the relationship between the strike price and the current market price of the asset, options can be categorised as in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). So, let us understand what ITM, ATM, and OTM call options are with the following illustration.
Let us assume that a trader is looking at Nifty 50 calls while the Nifty trades at ₹18,000. At the same time, don’t forget that, in the case of call options, you make money when the underlying asset’s price increases.
- ITM: ITM is when the contract’s strike price is less than the asset’s current market price. For the above case, if the Nifty 50 call’s strike price is below the current market price of ₹18,000, it is considered ITM. For example, if the call has a strike price of ₹17,500, it gives the holder the right to buy Nifty at a lower price than its current market value.
- ATM: ATM is when the strike price of the contract is equal to the prevailing market price of the underlying asset. For the above case, if the call’s strike price is close to the current market price, say ₹18,000, it is considered ATM. In this scenario, the strike price is in alignment with the prevailing market value.
- OTM: OTM is when the strike price of the contract is higher than the current market price. For the above case, if the call’s strike price is above the market price, like ₹18,500, it is considered OTM. The option does not possess intrinsic value as of now but may gain value if the market price rises in the future.
Conclusion
Call options provide investors the opportunity to benefit from the potential appreciation of an underlying asset without committing to its outright purchase. These financial instruments grant the holder the right, but not the obligation, to buy the asset at a predetermined price within a specified timeframe. Understanding call options involves grasping the concepts of strike prices, expiry dates, and the interplay of intrinsic and extrinsic values. By strategically utilising call options, investors can navigate market movements, hedge risk, and potentially amplify their returns in dynamic financial markets.
