Call Options: Learn the Basics of Buying and Selling

In the last section, we covered the fundamentals of call options and explained the important terms. Now, we will delve into the details of buying and selling call options. We will explore the motivations and strategies of both parties involved - the buyers, also known as holders, and the sellers, known as writers. By having a clear understanding of both perspectives, investors can make better choices when navigating the options market.

Buyer of a Call Option

The buyer of a call option is commonly known as the holder. 

A long call option is a contract that grants the investor the right, without any mandatory commitment, to purchase a specific asset at an established price, the strike price, before or by the time the contract expires.

To put it in more straightforward terms, buying a long call option means the investor is speculating that the price of the asset in question will climb higher than the strike price before the option's expiration date. Should the asset's price indeed rise, the investor has the opportunity to execute the option and purchase the asset at the lower strike price, potentially securing a profit.

On the other hand, if the asset's price doesn't surpass the strike price or even declines, the investor isn't compelled to act on the option and may simply allow it to expire without value. The financial loss in this scenario is confined to the initial premium paid for the option.

Understanding why investors choose to buy call options can provide valuable insight into their motivations and objectives in the financial markets.

• Speculation: One common reason investors buy call options is to speculate on the price movement of an underlying asset. For example, if an investor believes that a particular stock will increase in value in the near future, they may purchase call options on that stock to potentially profit from its upward price movement.
• Leverage: Call options offer the potential for significant returns with a relatively small initial investment. Since the premium paid for the option is typically lower than the cost of purchasing the underlying asset outright, call options provide leverage, allowing investors to control a larger position with less capital.
• Limited Risk: Purchasing call options offers a distinct advantage in terms of risk limitation compared to directly buying stocks. When an investor buys stocks outright, they face the possibility of unlimited losses if the stock's price falls. However, with call options, the investor's risk is confined to the amount paid for the option's premium, even if the underlying asset's price significantly drops. This means the call option buyer can lose the initial premium paid the most, no matter the decline in the asset's value.
• Hedging: Purchasing call options can serve as a protective measure or hedge within an investment portfolio. This strategy involves acquiring call options for assets an investor already possesses. It acts as a safety net, guarding against potential financial loss should those assets decrease in value.

Payoff of Buyer of Call Option

Now that we understand why investors buy call options, let's delve into the potential payoff for buyers of call options and how it varies depending on market conditions at expiration.

A useful tool for visualising the potential payoff of a call option is the payoff diagram. This diagram illustrates the profit or loss that the buyer of a call option can realise at expiration, based on different scenarios of the underlying asset's price.

Payoff = Max(0, S - K) - Premium

Where:

• S is the price of the underlying asset at expiration.
• K is the strike price of the option.
• Premium is the price paid by the buyer to purchase the option.

• The expression Max(0, S - K) represents the intrinsic value of the option at expiration. It calculates the positive difference between the price of the underlying asset (S) and the strike price (K), ensuring that the payoff cannot be negative.
• The Premium is subtracted from the intrinsic value to account for the initial cost paid by the buyer to purchase the option.

Suppose you purchase a call option on Company XYZ with the following details:

• Strike Price (K): ₹50
• Premium Paid: ₹3 per share
• Expiration Date: One month from now

• Scenario 1: At expiration, if the price of the underlying asset exceeds the strike price, the call option is in-the-money. In this case, the buyer of the call option can exercise the option and buy the underlying asset at the strike price, then immediately sell it at the market price for a profit. The payoff for the buyer of the call option is the difference between the market price of the underlying asset and the strike price after deducting the premium paid for the option. 

Price of Underlying Asset (S) = ₹55

Here, the price of the underlying asset is above the strike price (in-the-money).

So, Payoff = Max(0, 55 - 50) - 3

= Max(0, 5) - 3=2

The option is in-the-money, and the buyer exercises the option to buy shares at the strike price of ₹50. After deducting the premium paid (₹3 per share), the net profit per share is ₹2.

• Scenario 2: If the price of the underlying asset is below the strike price at expiration, the call option is out-of-the-money. In this scenario, the buyer of the call option will not exercise the option since it would result in a loss. The maximum loss for the buyer of the call option is limited to the premium paid for the option.

Price of Underlying Asset (S) = ₹45

In this scenario, the price of the underlying asset is below the strike price (out-of-the-money).

Payoff = Max(0, 45 - 50) - 3

= Max(0, -5) - 3

=-3;

Since the option is out-of-the-money, it expires worthless, and the buyer incurs a loss equal to the premium paid (₹3 per share).

• Break-Even Point: The break-even point for the buyer of a call option is the point at which the payoff from exercising the option equals the premium paid. It represents the price level at which the underlying asset must reach at expiration for the buyer to neither make a profit nor incur a loss. The payoff at Break-Even Point:

Price of Underlying Asset (S) = ₹53

Payoff = Max(0, 53 - 50) - 3

= Max(0, 3) - 3= 0;

At the break-even point of ₹53 per share, the option buyer's payoff is zero. This means the buyer neither gains nor loses money, as the profit equals the premium paid.

For buyers of call options, the potential for profit essentially has no ceiling, especially if the market price of the underlying asset climbs well beyond the strike price.

Understanding the potential payoff of buying a call option is crucial for investors to assess the risk-reward profile of their investment and make informed decisions. 

Selling/Writing a Call Option

After looking at the perspective of the buyer of a call option, let's shift our focus to the seller, also known as the writer, of a call option. 

A short call option refers to a type of options contract where the seller, also known as the writer, has the obligation to sell the underlying asset at a predetermined price (known as the strike price) if the option is exercised by the buyer before or at expiration.

Put simply, by selling a short call option, an investor is in agreement to assume the responsibility of selling the specified asset at the agreed-upon price, should the option's buyer opt to execute this right.

In exchange for taking on the obligation to sell the underlying asset, the seller of the call option receives a premium from the buyer. This premium represents the income earned by the seller for undertaking the obligation.

Selling a call option comes with limited potential profit but unlimited risk. If the price of the underlying asset goes over the strike price, the seller may have to sell the asset at a lower price than its market value, resulting in a loss.

There are two methods for selling call options:

• Naked Call Option: With a naked call option, the seller offers the option without owning the underlying asset. This approach carries significant risk because if the buyer exercises the option, the seller must purchase the asset at the current market price to fulfil the obligation. Sellers of naked call options face substantial risk since there's no cap on the asset's price, potentially resulting in significant losses. To compensate for this risk, sellers typically charge a higher fee. Naked call options are commonly utilised by large corporations to effectively diversify risks.
• Covered Call Option: In a covered call option, the seller owns the underlying asset, providing coverage for the option. By selling this option, the seller earns a risk-free profit from the premium received for the call option. However, if the asset's price experiences a significant increase, the seller won't benefit beyond the strike price. In this scenario, the option can only be sold at the predetermined strike price.

Investors may choose to sell call options as part of a strategy to generate income or to profit from neutral or bearish market expectations. By selling call options on assets they believe will not significantly increase in value, investors can earn premium income while potentially avoiding the obligation to sell the asset.

Payoff of a Short Call Option:

The potential payoff for the seller of a call option is limited to the premium received. If the option expires without any worth (out-of-the-money), the seller keeps the premium as profit. However, if the option is exercised (in-the-money), the seller may incur losses if the price of the underlying asset exceeds the strike price by a significant margin.

Let's consider an example to illustrate the payoff of a short call option:

You sell a call option on Company ABC with the following details:

• Strike Price (K): ₹60
• Premium Received: ₹4 per share
• Expiration Date: One month from now

Now, let's examine the payoff under different scenarios at expiration:

• Scenario 1: In this scenario, the price of the underlying asset is below the strike price (out-of-the-money).

Price of Underlying Asset (S) = ₹55

Payoff = Premium Received - Max(0, 55 - 60)

= 4 - Max(0, -5)

= 4;

Since the option is out-of-the-money, it expires worthless, and the seller retains the entire premium received as profit.

• Scenario 2: Here, the price of the underlying asset is above the strike price (in-the-money).

Price of Underlying Asset (S) = ₹62

Payoff = Premium Received - Max(0, 62 - 60)

= 4 - Max(0, 2) = 2;

The option is in-the-money, and the seller is obligated to sell shares at the strike price of ₹60. After deducting the premium received, the net profit per share is ₹2.

• Scenario 3: Price of Underlying Asset (S) = ₹58

In this scenario, the price of the underlying asset is close to the strike price (near-the-money).

Payoff = Premium Received - Max(0, 58 - 60)

= 4 - Max(0, -2)=4;

The option is near-the-money, resulting in the same payoff as the premium received (₹4 per share).

For the call option seller, the maximum potential profit is limited to the premium received from selling the option. The seller's potential loss is unlimited, as they may be required to sell the underlying asset at a lower price than its market value.

Understanding the dynamics of selling call options is essential for investors looking to incorporate option writing strategies into their investment approach. 

To Conclude

Both buyers and sellers of call options can calculate their respective profits or losses at expiration based on the prevailing market price of the underlying asset and the strike price.

By understanding the potential payoff and profit scenarios for call option transactions, investors can make informed decisions and implement strategies that align with their investment objectives and risk tolerance levels. Whether you're considering buying or selling call options, it's essential to weigh the potential rewards against the associated risks. You must also conduct a thorough market analysis before entering into any option contract.

We will explore put options in the next chapter.