Call Options Basics and How It Works in Practice?

What Is a Call Option?

A call option is a financial contract that gives the holder the right, but not the obligation, to buy a specific quantity of an underlying asset at a predetermined price, i.e. the strike price, before a given expiry date. Once the expiry date passes, the right to buy the underlying asset ceases to exist.

Call options are often used by investors to potentially profit from the price increase of an asset without actually owning the asset. If the asset’s price exceeds the strike price before or on the expiration date, the call option holder can choose to exercise the option and buy the asset at the lower strike price, realising a profit. However, if the asset’s price doesn’t reach or exceed the strike price by the expiration date, the call option may expire worthless, and the holder would lose the premium paid for the option.

A call option is a right to buy without an obligation, which means you can choose to execute an option contract when it is profitable.

A Guide To Call Buying Strategy

Traders buy call options when they are bullish on an underlying asset because it allows them to leverage. Let’s try to understand the situation with the help of an example.

Assume that the stocks of ABC company are selling at a spot price of ₹50. Now, you buy 100 contracts at ₹3 premium per contract and at a strike price of ₹55. Suppose that after 1 month, the shares are trading at ₹65. You will then stand to make a profit of ₹. Here is how.

Spot price – Strike price = ₹65 – ₹55 = ₹10 

This is because you can notionally buy the stock at ₹55 as per the call option and then sell them in the spot market at ₹65.

Total notional gain = ₹10*100 = ₹1,000 

Premium paid = ₹3*100 = 300 

Total profit = (₹1,000-₹300) = ₹700

What Is Leverage in Call Option?

 In the above example, if you’re going to buy the stocks, you will have to invest (₹50*100) or ₹5,000. Or, you have the option to buy call options at ₹300, i.e. 100 contracts at ₹3 per contract (₹3*100 = ₹300). You can benefit from the same number of shares by buying a call option with much less investment.

The profit potential is unlimited in both cases if the market continues to move in the current direction. But if we have to estimate the loss, it is limited to ₹300 with the call option. But if you buy only stocks, you can lose the entire investment if the market slides. In this case, the call option functioned as a hedge against market risks. You can also close your position and exit the trade with the call option. 

ITM, ATM and OTM Call Options

Call options are further divided into types, i.e. In-the-Money (ITM), At-the-money (ATM) and Out of the Money (OTM). 

• In-the-money (ITM) call options are those where the market price is higher than the strike price. 
• If the strike price and spot price are close, then the option is said to be at-the-money (ATM).
• The out-of-the-money (OTM) call option is one where the market price is lower than the strike price. 

If the market price of Infosys is ₹1,000, then ₹980 Call Option will be ITM while ₹1,020 Call Option will be OTM. 

Factors Influencing the Price of the Call Option

1. Intrinsic Value: This is the inherent value of the option based on the difference between the underlying asset price and the strike price. In-the-money call options (underlying price above strike) have positive intrinsic value, while out-of-the-money calls (underlying price below strike) have no intrinsic value. Higher intrinsic value generally leads to a higher premium.
2. Time to Expiration: As the expiration date approaches, the time value of the option diminishes, lowering the premium. Options with longer time to expiration have more potential for the underlying asset to move in the buyer’s favour, hence a higher premium.
3. Implied Volatility: This reflects market expectations for future price movements of the underlying asset. Higher expected volatility leads to a higher premium, as it increases the chance of the option becoming profitable before expiry.
4. Interest Rates: Higher interest rates generally decrease call option premiums. This is because holding an option involves an opportunity cost compared to earning interest on a risk-free investment.
5. Greek Values: These are metrics that measure the sensitivity of the option price to changes in various factors like the underlying asset price (delta), volatility (gamma), interest rates (rho), and time to expiration (theta). You can learn more about option greeks here. 

Significance of Time Value in Call Option

As we saw earlier, the option premium is the price that the buyer pays the seller to get the right to buy without the obligation to buy. This option premium has two components: time value and intrinsic value. 

Premium = Intrinsic Value + Time Value

The intrinsic value is the price profit, while the time value is based on the probability of the option becoming profitable. All ITM options will have intrinsic value and time value, while OTM options will only have time value.

Let us understand this with a call option example. Assume that Infosys is trading at ₹1,000. Let us look at various scenarios of call option strike prices and how the split of time value and intrinsic value are worked out.

From the above table it is clear that OTM call options only have time value, while ITM options have time value and intrinsic value.

Understanding Options Trading in India

Cash Settlement of Options

In India, all options are cash-settled! What does that mean? It means that on the settlement date, the profits will be adjusted in cash. Just because you have a TCS call option, you cannot go to the exchange and demand that you get delivery of shares of TCS. 

Index Call Option and Stock Call Option

An index call option is the right to buy an index, and the profit/loss will depend on the movement in the index value. Thus, you have Nifty Calls, Nifty Bank calls, etc. Stock options are options on individual stocks. Thus, you have call options on Reliance Industries, Tata Motors, Infosys, etc. The principle of trading call option in both cases is the same. You buy a call option when you expect the price of the stock or index to go up.

Monthly and Weekly Expiry 

Call options on stocks are available in near-month, mid-month and far-month contracts with expiry on the last Thursday of the month. Call options on indices can have weekly, monthly and even quarterly expiries.

The following indices have options with weekly expiry:

If the designated day is a holiday, then the previous trading day is usually considered the expiry day.

European Call Option and American Call Option

An option that can only be exercised on the settlement date is called a European option, while an American option can be exercised on or before the settlement date. In the past, stock options were American, while Index options were European. Now, all options have shifted to being European options only. 

Note: At the end of the option contract’s name, if you see a ‘CE’ then that denotes the option being a call European option. 

Weekly and Monthly Call Options

Monthly call options are the normal options that expire on the last Thursday of the month and are popularly traded. Recently, SEBI and the exchanges introduced a new product called weekly options, specifically with respect to Bank Nifty. The idea was to reduce the risk of options by making the expiry each week. These weekly options have attracted quite a bit of interest from traders recently.

Key Takeaways

• Call options are financial contracts that give the holder the right to buy an underlying asset at a strike price on a future date.
• Executing a call option is profitable when the strike price is lower than the market price at the time of expiry.
• The market price of the call option is called a premium. It is determined based on two factors, i.e. the difference between the spot and strike price of the underlier and the length of time until the option expires.

Final Words

Trading options is a useful option strategy to increase your market exposure without infusing lots of funds. As we have seen, options trading in India offers a good way to participate in the markets with limited risk. If the above information interests you, you can trade options on Angel One by opening a demat account online.

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