Chapter 1 - Introduction to Call Options: A Detailed Overview

What Is a Call Option?

Call options represent a unique financial agreement granting the buyer the privilege, rather than the obligation, to acquire a specified asset, be it a stock, bond, or commodity, at a predetermined price within a defined timeframe.

The Call Options buyer possesses the right, but not the obligation, to exercise their call options and buy stocks, while the call seller is obligated, but lacks the right, to deliver stocks if assigned.

When a call buyer sees the underlying asset's price rise, they reap profits. This uptick may stem from various factors like favorable company updates or acquisition news. Conversely, if the price dips below the strike at expiry, the seller benefits from the premium, assuming the buyer doesn't exercise the option. Contrary to call options, put options grant the holder the authority to sell (or compel the buyer to buy) the asset at a predetermined price on or before expiry.

Advantages of Call Options

• Accessibility: Unlike traditional equity investments that demand substantial capital, call options offer a cost-effective entry point. Investors pay only the premium, making it accessible to a broader range of investors.
• Risk Management: Call options present lower risks compared to direct equity investments. Their limited downside potential is defined by the premium paid, shielding investors from substantial losses in volatile markets.
• Income Generation: Investors can leverage call options to generate additional income through covered calls. By selling call option contracts on appreciated assets, investors earn premiums, enhancing their overall returns through strategic options trading.

Important Options Terms

Options represent opposing positions taken by two investors: one betting on a decline in asset price, while the other anticipates a rise, typically involving stocks, bonds, or commodities. Here are a few Options terms that traders should know.

• Contract: A contract is a financial agreement granting the option to purchase an asset at a predetermined price by a specified expiration date.
• Expiry Date: The expiry date marks the end of a financial contract or asset's validity. In derivatives trading, like futures and options, it signifies the contract's termination.
• Strike Price: The strike price is the agreed-upon value at which the option contract can be exercised. It's predetermined and impacts the option's profitability.
• Premium: The premium is the cost paid to buy an option, reflecting its intrinsic value. It's lost if the option expires worthless.
• Options settlement: Options settlement is the process where options contracts are resolved financially or physically, depending on whether they are in or out of the money at expiration.

Understanding Call Options with Money

Let us understand how Call Options work with an example...

Let’s assume that XYZ company’s stocks are valued at Rs.100 each. An investor who owns 100 of XYZ company’s stocks wants to make extra profit from it beyond the dividend. He expects the stocks to go above Rs.120 in the coming month, therefore, he chooses to assess Call Options.

He sells one Call Option and gets Rs.30 as a premium. In total, he receives a premium of 3000 (Rs.30 x 100 shares).

Here are a few potential outcomes of this scenario.

Long vs. Short Call Options

The long call strategy, commonly used in stock options trading, anticipates a significant rise in the underlying asset's market price before expiry. Investors pay a premium for the option, aiming for enhanced profits if prices surge, yet risking losses if they decline below the strike price.

For instance, consider stock XYZ with a current price of Rs.500 per share. Investor A purchases a call option with a strike price of Rs.550 and an expiry in one month, expecting XYZ's price to rise to Rs.550. Investor A has the right to buy 100 shares of XYZ at Rs.550 until expiry. Assuming a premium of Rs.20 per share, Investor A pays Rs.2000 to the option writer, limiting potential losses. If XYZ's price rises to Rs.600, Investor A can exercise the option, buying shares at Rs.550 and selling them at Rs.600, yielding a profit of Rs.50 per share. However, if XYZ's price remains below Rs.550, the option expires worthless, resulting in a Rs.2000 loss for Investor A.

A short call entails selling the obligation to sell shares at a predetermined price, typically above the current market price. This strategy is utilized by investors seeking to generate income by collecting the premium paid by the buyer of the call option.

However, there are two variations: covered and uncovered short calls. In a covered call, the seller owns the underlying stock, mitigating risk in case of assignment. Conversely, an uncovered call, also known as a naked call, carries higher risk as the seller doesn't own the stock, potentially resulting in unlimited losses if the stock price exceeds the strike price.

Consider stock XYZ with a current price of Rs.600 per share. Investor B sells a call option with a strike price of Rs.650 and an expiry in one month, believing XYZ's price won't exceed Rs.650. Investor B receives a premium of Rs.30 per share, totaling Rs.3000 for the option contract. If XYZ's price remains below Rs.650, the option expires worthless, and Investor B retains the entire premium as profit. However, if XYZ's price exceeds Rs.650, the option buyer can exercise it, and Investor B must sell 100 shares at Rs.650, regardless of the market price, potentially resulting in a loss.

How Do Call Options Work?

As call options derive their value from an underlying asset, like a stock, their prices fluctuate based on the asset's market performance. For instance, buying a call option for XYZ at a strike price of Rs.150 with expiry on December 31 grants the right to purchase 100 shares of XYZ at Rs.150 anytime before or on December 31.

Moreover, the option buyer can sell the contract to another buyer at the prevailing market rate before expiry. If the underlying asset's price remains stable or decreases, the option's value diminishes as it approaches expiry.

Call Options Serve Dual Purposes for Investors

• Speculation: Investors leverage call options to speculate on potential stock price increases, requiring only a fraction of the capital needed to buy actual shares. This high-risk, high-reward strategy offers unlimited profit potential and limited losses, typically the premium paid.
• Hedging: Institutions utilize call options as hedging tools akin to insurance. Employed opposite to a position, they mitigate potential losses on the underlying asset in case of unexpected events. Calls can be purchased to hedge short stock portfolios or sold to protect against declines in long stock holdings.

Scenario 1: The Nifty 50 Price Falls to Rs.22,800 on Expiry

If Nifty 50 were to be at Rs.23,100, the option buyer would exercise the option because they can buy the stock at Rs.22,900 and sell it at the market price, making a profit of Rs.100. However, since they’ve already paid a premium of Rs.50 towards the contract, the total profit stands at Rs.50 (Rs.100 - Rs.50).

Scenario 2: The Nifty 50 Closes at Rs.23,100 on Expiry

The break-even point refers to the price at which an investor neither gains nor loses money on a trade. It's the price level where the total cost of acquiring the asset is equal to the total proceeds from selling it. Here, the BEP is Rs.22,950 (Strike price + Premium).

Scenario 3: Nifty 50 Reaches Rs.25,000 on Expiry

The break-even point refers to the price at which an investor neither gains nor loses money on a trade. It's the price level where the total cost of acquiring the asset is equal to the total proceeds from selling it. Here, the BEP is Rs.22,950 (Strike price + Premium).

Why Would You Buy a Call Option?

The buyer of a call option, known as the holder, buys with anticipation of a price surge surpassing the strike price before expiry. Profit equals sale proceeds minus strike price, premium, and associated fees. Failure to exceed the strike price results in a loss equivalent to the call option premium.

Suppose a buyer buys a call option for Rs.500 on a stock with a strike price of Rs.1500 and an expiry in one month. They anticipate the stock's price will rise above Rs.1500 before expiration. If it does, and the stock reaches Rs.1600, they can exercise the option, profiting Rs.100 per share. However, if the stock remains below Rs.1500, they lose the Rs.500 premium paid for the option.

Should You Sell a Call Option?

Call option sellers, also known as option writers, engage in selling call options with the expectation that these options would expire worthless, allowing them to profit from the premiums received. They essentially play the role of insurance providers, selling the right to buy the underlying asset at a specified price (strike price) within a certain period (until expiration).

Covered Call Option

Call option sellers, also known as option writers, engage in selling call options with the expectation that these options would expire worthless, allowing them to profit from the premiums received. They essentially play the role of insurance providers, selling the right to buy the underlying asset at a specified price (strike price) within a certain period (until expiration).

Naked Call Option

Call option sellers, also known as option writers, engage in selling call options with the expectation that these options would expire worthless, allowing them to profit from the premiums received. They essentially play the role of insurance providers, selling the right to buy the underlying asset at a specified price (strike price) within a certain period (until expiration).

In both scenarios, if the call option buyer chooses not to exercise their right to buy the underlying asset, the seller keeps the premium received as profit. However, if the buyer exercises the option profitably, the seller may face losses, especially in the case of naked call options where there is no limit to how high the stock price can rise. To mitigate potential losses, sellers often demand higher premiums when selling naked call options.

Difference Between Call Option and Put Option

Put options offer investors an avenue to profit from a decline in stock prices. Unlike call options, which gain value when stocks rise, put options become more valuable as stock prices fall. This allows traders to capitalize on downward movements in the market.

• Potential for High Returns: Similar to call options, purchasing put options presents the opportunity for substantial returns relative to the initial investment. If the stock price decreases significantly, the put option buyer stands to make considerable profits.
• Risk of Total Loss: However, like call options, buying put options carries the risk of losing the entire investment if the option expires without being exercised. If the stock price remains above the strike price, the put option becomes worthless, resulting in a total loss for the buyer.
• Premium Income and Risk Exposure: Selling put options, akin to selling call options, allows investors to earn premiums. However, this strategy exposes the seller to significant risks if the stock price moves unfavorably. While the potential losses are capped since stock prices cannot drop below zero, the seller could still incur substantial losses, potentially exceeding the premium received.
• Put options serve as a versatile tool for investors seeking to profit from declining stock prices, offering both opportunities for substantial gains and risks of significant losses, depending on the chosen strategy.

Factors Influencing the Price of Call Option

Understanding the factors that influence option pricing is crucial for investors to make informed decisions in the derivatives market. Here are key determinants to consider:

• Intrinsic Value: Represents the difference between the underlying asset's price and the option's strike price.
• Time to Expiration: As the option's expiration date nears, its time value diminishes, affecting the premium.
• Implied Volatility: Reflects market expectations for future price movements, impacting the option premium.
• Interest Rates: Higher rates tend to decrease call option premiums due to opportunity cost.
• Greek Values: Metrics like delta, gamma, rho, and theta measure option price sensitivity to underlying factors.

Options Trading in India

Options trading offers a versatile platform for investors to capitalize on market movements. Understanding the nuances of options settlement, types, and expiry dates is crucial for navigating this dynamic financial landscape.

• Settlement in Cash: In India, options are settled in cash, meaning profits are adjusted in cash on the settlement date. Unlike stock options, you can't demand physical delivery of shares.
• Index vs. Stock Options: Index call options provide the right to buy an index, with profits/losses tied to index movement (e.g., Nifty Calls). Stock options are on individual stocks like Reliance Industries or Tata Motors, traded similarly.
• Expiry Dates: Stock call options offer near-month, mid-month, and far-month contracts expiring on the last Thursday of each month. Index call options may have weekly, monthly, or quarterly expiries.

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