First, what is the call option?
A call option is an option contract; don’t know what futures and options are? Read our blog – Futures Vs. Options. Coming back, the call option is basically an option contract where the buyer can rightfully, but not obligatorily buy the security being traded at the specified price within the period of its expiration. However, the obligation to sell the security at the strike price lies with its seller in case the option is exercised. The seller is paid a premium for shouldering the risk that comes along with this obligation.
As for stock options, each ‘contract’ covers 100 shares.
Trading in call options?
Buying and selling call options:
Let me try and explain the concept and its related jargons vide an example.
Consider a hypothetical situation where a buyer has the right to buy 100 shares of a company for a fictitious value of Rs. 1000 each. Here, Rs. 1000 is referred to as the strike price. Now, as mentioned above, the buyer has the right to buy these shares at the mutually agreed price irrespective of any fluctuations in the stock market price (while it’s within its expiration period). In case the price of the share appreciates saying Rs. 1500, the buyer has made a profit of Rs. 50,000 less the cost of the option. At this point, the buyer has to pay a fee known as ‘premium’ to the seller. Given that the premium is Rs. 40, the total premium value the buyer would end up paying is Rs. 40 * 100 = Rs. 40,000/- and would thereby make a profit of Rs. 46,000/-.
However, if the stock depreciates in value, the buyer in most cases won’t see the need to buy the stock for the higher cost and would most probably end up losing the Rs. 40,000/-. Alternatively, they could try selling the option in order to avoid taking a full loss.
Types of call options (while selling)
- Covered calls
In cases where the call option buyer is obligated to buy the security, the short call is said to be ‘covered’. This is a popular option strategy that allows the stock owner to beget additional income from their holdings. There are strategies that can be developed around this move, however, given that it is beyond the scope of this post, I will not delve into it.
- Uncovered (or Naked) calls
Uncovered calls are the opposite of covered calls. It’s essentially the situation where the buyer does not hold the underlying security. However, popular opinions say that this is a highly risky strategy to adopt and isn’t ideal for a novice trader to follow. There are strategies that can be developed around this move too, but once again, given that it is beyond the scope of this post, I will not delve into it further.
Hope this article helped you learn about what Call Option Trading is, and how you can use it as a tool of investment.