Call Option

Call Option

Definition

A call option is a financial contract that gives the holder the right, but not the obligation, to buy a specified asset at a predetermined price within a set period.

Description

Call Option meaning is like reserving the option to buy something later, offering flexibility without being forced to purchase. The buyer can exercise the option if the asset's market price exceeds the predetermined price, potentially profiting from the difference. 

However, if the market price remains below the predetermined price, the buyer can let the option expire without buying the asset.

For this right, the call buyer will pay a premium, which the seller will receive. Unlike stocks, which can live in perpetuity, an option will cease to exist after expiration, ending up worthless or with some value.

The following components comprise the significant traits of an option:

• Strike price: The price at which you can buy the underlying stock
• Premium: The price of the option, for either buyer or seller
• Expiration: When the option expires and is settled

Importance of Call Trade Option

Call options hold several vital roles:

1. Risk Management: It enables investors to hedge against potential losses by giving them the right to buy assets at a predetermined price, regardless of market fluctuations.
2. Flexibility: Call options offer flexibility as they provide the option, but not the obligation, to purchase assets. This allows investors to capitalise on favourable market movements while limiting downside risk.
3. Leverage: Call options enable investors to control a more prominent position of assets with a relatively small investment, potentially amplifying returns if the market moves in their favour.
4. Speculation: Investors can use call options to speculate on the future price movements of assets, potentially earning profits from anticipating market trends without directly owning the underlying assets.
5. Portfolio Diversification: Including call options in an investment portfolio can diversify risk and provide exposure to different asset classes, sectors, or markets.

How does the call option work?

A call option gives the holder the right, but not the obligation, to buy a specific asset, such as stocks or shares, at a predetermined price (known as the strike price) within a certain period (until the expiration date).

Here's how it typically works:

1. Purchase: An investor purchases a call option contract and pays the option's seller (the writer) a premium.
2. Contract Terms: The call option provides the underlying asset, the strike price, the expiration date, and the premium payable.
3. Market Movement: The call option gains value if the underlying asset's market price climbs over the strike price before the expiration date.
4. Option Exercise: The option holder may exercise the call option by purchasing the underlying asset at the strike price, regardless of its current market price. They can either keep the asset or sell it at a higher market price for a profit.
5. Profit Potential: The profit for the call option holder is calculated as the difference between the asset's market price and the strike price minus the premium paid for the option.
6. Expiration: If the asset's market price remains lower than the strike price at expiration, the call option is worthless, and the investor loses merely the premium paid for it.
   
    

Trends that can affect the call option.
 

These are the trends that can affect the call option:

1. Market Volatility: Volatility measures how much the underlying asset's price fluctuates. Higher volatility frequently means more uncertainty and risk in the market. Call options flourish in volatile markets because they allow significant gains when prices move in the desired direction. In contrast, low volatility may affect the value of call options due to lower price changes.
2. Underlying Asset Price Movement: Call options allow investors to buy the underlying asset at a fixed price, known as the strike price. As a result, any price change in the underlying asset directly influences the value of the call option. Bullish tendencies, defined by rising asset prices, often drive up call option prices as investors anticipate more significant gains. Conversely, bearish trends, characterised by declining prices, may reduce call option values as the possibility of profit falls.
3. Interest Rates: Interest rates affect the cost of capital and investment decisions. Higher interest rates tend to raise call option prices because they increase the present value of prospective future cash flows from holding the underlying asset. Lower interest rates, on the other hand, might drive down call option prices by lowering the opportunity cost of investing in options.
4. Company Earnings Reports: Earnings reports give critical information about a company's financial performance and development prospects. Positive earnings surprises or optimistic expectations frequently result in greater demand for call options, which leads to higher prices. In contrast, negative financial results or pessimistic outlooks may trigger a drop in call option pricing as investor confidence wanes.
5. Market Sentiment: Market sentiment shows investors' general mood and attitude toward the market or individual assets. Positive emotions about economic conditions or corporate advancements can increase demand for call options, causing prices to rise. In contrast, negative sentiment caused by concerns about financial instability or geopolitical tensions may reduce call option prices as investors become more risk-averse.
6. Global Events: Geopolitical events, economic indicators, and geopolitical tensions can considerably impact financial markets. Unexpected events, such as geopolitical wars, natural disasters, or unexpected policy decisions, can destabilise market dynamics and cause volatility. Call option prices may respond appropriately, indicating shifts in investor sentiment and risk perceptions.
7. Expiration Dates: Call options have a finite lifespan, with expiration dates dictating when holders can exercise their rights. As the expiration date approaches, the time value of call options decreases significantly if the underlying asset's price does not move in the expected direction. This effect, known as time decay, can reduce the value of call options, making them less appealing to investors.

Example
 

Let's say you're interested in purchasing call options for Company XYZ, which currently trades at ₹3,000 per share. You believe Company XYZ's stock price will increase shortly due to favourable market sentiment and upcoming product launches.

You decide to buy a call option contract for 100 shares of Company XYZ with a strike price of ₹3,300 per share and an expiration date one month from now. The premium for this call option contract is ₹100 per share, totalling ₹10,000 (₹100 premium x 100 shares).

Scenario 1: Stock Price Rises

Before the expiration date, Company XYZ's stock price increases to ₹3,600 per share. Since the market price is now higher than the strike price of ₹3,300, your call option has intrinsic value. You decide to exercise your call option and buy 100 shares of Company XYZ at the predetermined price of ₹3,300 per share, even though the market price is ₹3,600 per share. This allows you to immediately sell the shares at the market price of ₹3,600, generating a profit of ₹30,000 (₹3,600 market price - ₹3,300 strike price x 100 shares) minus the premium paid of ₹10,000, resulting in a net profit of ₹20,000.

Scenario 2: Stock Price Remains Below Strike Price

If Company XYZ's stock price remains below the strike price of ₹3,300 per share at expiration, your call option expires worthless. Since the market price did not reach the strike price, the option has no intrinsic value. In this case, you lose the premium paid for the call option contract, which is ₹10,000.

 

FAQ
 

What is a Call Option?

A call option is a financial contract granting the holder the right, but not the duty, to purchase a specific item (such as stocks, commodities, or currencies) at a defined price within a set period.

What is a Put Option?

A put option is a financial contract that gives the holder the right, but not the responsibility, to sell a particular asset (such as stocks, commodities, or currencies) at a fixed price within a set period.

How do Call and Put Options Work?

Call options benefit the holder when the underlying asset's market price exceeds the fixed price (strike price), allowing them to purchase the asset at a reduced cost.

Put options benefit the holder when the underlying asset's market price falls below the predefined price (strike price), allowing them to sell it for a higher price.

What is Options Trading in India?

• Options trading in India entails purchasing and selling options contracts on recognized exchanges such as the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
• It lets investors speculate on underlying asset price fluctuations, hedge against risks, and profit by utilising options contracts.

How are Options Prices Determined in India?

Factors influencing options prices in India include the underlying asset's current market price, strike price, time before expiration, volatility, and interest rates.

All of these elements determine the premium or price of an options contract.
 

What are the Risks and Benefits of Options Trading in India?

Risks include the potential loss of the premium paid if the option expires worthless and the risk of market volatility and adverse price movements.