Understanding the Importance and Factors of Call Option

We explored the methods to value options in the previous chapter. We will now study an important aspect of option trading- call options. Call options are a key idea in finance, giving investors a special way to guess how the price of an asset might change. They are agreements that grant the purchaser the privilege to buy the underlying asset at a set price before a specified expiration date. This underlying asset can be a bond, stock, or another type of security.

These are just like thousands of hidden opportunities in the stock market that you can exploit to make profits even when the stocks are little positioned.

Let us now start by getting into the nature of call options, and explore their applications in the real world and beyond. 

Understanding Components of Call Options

Below are the important parts of call options:

• Underlying Asset: A call option gives the buyer the privilege, without the necessity, to purchase a designated asset, like stocks, commodities, or currencies, at a specific price known as the strike price within a set timeframe leading up to its expiration.
• Strike Price: This is the designated price for purchasing the underlying asset if the holder decides to execute the call option. It represents the price mutually agreed upon by the buyer and the seller.
• Expiration Date: Call options are constrained by a finite duration, known as their expiration date. This date marks the deadline by which the option holder must decide whether to exercise their right to buy the underlying asset.
• Premium: To acquire a call option, the buyer pays a premium to the seller. This premium represents the cost of obtaining the option and varies based on factors such as the current price of the underlying asset, the strike price, the time until expiration, and market volatility.

Intrinsic Value of a Call Option

The intrinsic value of a call option represents the portion of its total value that is attributed to the difference between the current price of the underlying asset and the strike price of the option. 

Mathematically, the intrinsic value of a call option can be calculated using the formula below:

Intrinsic Value = Current Price of Underlying Asset - Strike Price

Here's a breakdown of the concept:

• In-the-Money Option: When the existing value of the underlying asset surpasses the strike price of the option, it's deemed "in-the-money" (ITM). In such instances, the call option possesses intrinsic value as it enables the holder to procure the underlying asset at a price below its current market value.
• At-the-Money Option: When the present value of the underlying asset matches the strike price of the option, the option is termed "at-the-money" (ATM). In this scenario, the option lacks intrinsic worth since there are no profits to be derived from its exercise.
• Out-of-the-Money Option: When the market value of the underlying asset descends below the strike price of the option, it is categorised as "out-of-the-money" (OTM). In these circumstances, the option holds no intrinsic worth as its execution would result in a monetary deficit, considering the asset is procurable at a lower cost elsewhere in the market.

The intrinsic value of a call option represents the minimum value that the option should have, as it reflects the immediate profit that could be realised by exercising the option. Any additional value beyond the intrinsic value is referred to as the time value of the option, which reflects factors such as time left until expiration, volatility, and interest rates.

Significance of Time Value of a Call Option

The time value of a call option represents the portion of its premium that is attributed to the amount of time remaining until the option expires. 

Mathematically, Time Value = Premium - Intrinsic Value

It is an essential component of an option's price and holds significant importance for both option buyers and sellers. Here's why:

• Decay Over Time: As the expiry date of an option draws closer, the time value associated with it gradually decreases. This decrease is due to the diminishing window for the asset's price to shift in a beneficial direction. Consequently, the time value is indicative of the pace at which the option's worth reduces over time, a concept commonly referred to as time decay or theta decay.
• Risk Management: For option buyers, the time value represents the risk associated with the uncertainty of whether the option will move into a profitable position before expiration. Since time value decreases over time, option buyers face the risk of losing this portion of the premium if the underlying asset's price does not move sufficiently in the desired direction.
• Profit Potential: Despite the risk of time decay, time value also offers profit potential for option buyers. If the underlying asset's price moves in a favourable direction, the option's intrinsic value (the difference between the asset's price and the strike price) increases, in addition to any remaining time value. Therefore, option buyers may profit from both price movements and changes in time value.
• Income Generation: For option sellers, time value represents potential income. By selling options with significant time value, sellers can collect premiums upfront and potentially profit if the options expire worthless due to time decay. However, sellers must be cautious, as they are exposed to the risk of adverse price movements in the underlying asset.

The time value of a call option is influenced by several factors, which include:

• Time to Expiration: The time remaining until an option expires is referred to as the time to expiration and significantly impacts its time value. Typically, call options that expire further in the future hold a greater time value than those nearing expiration. This increase in time value for longer-duration options stems from the enhanced chance that the asset's price could move favourably within the extended timeframe.
• Volatility: Volatility describes how much the price of an asset fluctuates. When an asset's price shows higher volatility, it means there's a bigger chance for substantial price changes in the future, enhancing the likelihood that the option will become profitable (or in-the-money). Consequently, options linked to assets with high volatility usually carry greater time values than those connected to assets with lower volatility.
• Interest Rates: Interest rates also impact the time value of a call option. The cost of carrying the underlying asset increases when the interest rates are high. This translates to a higher time value for call options. Lower interest rates, on the other hand, reduce the cost of carrying the asset and, thus, the time value of call options.

• Dividends: For stocks that pay dividends, the timing and amount of dividends can affect the time value of call options. Generally, call options on dividend-paying stocks tend to have lower time values due to the anticipated decrease in the stock price when dividends are paid. This is because dividends reduce the value of the underlying asset, leading to lower option premiums.
• Market Sentiment: Market sentiment, including factors such as investor optimism or pessimism, can also influence the time value of call options. Positive market sentiment may lead to higher time values, as investors are willing to pay more for options with greater profit potential. On the other hand, negative sentiment may result in lower time values for call options.

Overall, these factors interact to determine the time value of a call option, reflecting the market's expectations of future price movements and the associated risk. 

Now, let’s explore a practical example to illustrate how call options work in real-life scenarios.

Suppose in January, the shares of Company X are trading at ₹80. You strongly believe that the share prices will surge in the coming months. To potentially profit from this anticipated increase, you opt to purchase a six-month call option, granting you the right to buy 50 shares of Company X at ₹90 each by July 31st. You pay a premium of approximately ₹150 for this call option, assuming a cost of ₹3 per share, as options are typically traded in lots of 50 shares.

Situation 1: Fast forward to June 15th, and the shares of Company X are trading at ₹100. In this scenario, you can exercise your call option, purchasing 50 shares of Company X at the predetermined price of ₹90 each. Subsequently, you can sell these shares at the market price of ₹100 each, yielding a profit of ₹500 (₹10 profit per share x 50 shares) minus the initial investment of ₹150.

Situation 2: Alternatively, if the share prices of Company X do not increase as expected during the six-month option period and fail to reach ₹90, you have the option to let the call option expire. In this case, the only loss you incur is the initial premium paid of ₹150, as you are not obligated to buy the shares at the predetermined price.

This example illustrates how a call option provides the potential for profits if the market moves in your favour while limiting potential losses to the premium paid if the market moves against your expectations.

Wrapping Up

Call options offer a strategic avenue for investors to limit their losses and reap significant profits. We will explore other aspects of call options in the next chapter.