What is a Call Option & How does it work?

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A call option in the F&O market is a type of financial derivative contract that gives the buyer the right, but not the obligation, to buy an agreed quantity of a particular underlying asset at a predetermined price (strike price) on or before a specified date (expiration date). The buyer pays an upfront fee (premium) to purchase the call option.

Call options are one of the two main types of options, the other being put options. Calls are optimistic or bullish contracts as the buyer expects the price of the underlying asset to rise in the future. Option trading in India often has several factors which any trader should know before trading.

How Does a Call Option Work?

There are two sides to call options – the holder (buyer) and the seller (writer). Here is how call options work for each party:

For Call Buyers

Pay premium – The call buyer pays an upfront premium to the seller to buy the call option. This gives them the right to buy the underlying asset later.

Buy on exercise – The buyer can exercise the call option on the expiration date if the underlying asset price is higher than the strike price. On exercise, they can buy assets from sellers at strike price. 

Profit potential – Buyer profits if asset price rises above strike price + premium paid. Their loss is limited to the premium paid.

Let option expire – If the asset price is below the strike price on expiry, the buyer can let the option expire worthless. Loss is limited to the premium.

For Call Sellers

Receive premium: For selling or writing the call option, the seller receives the premium amount from the buyer. This is their maximum profit.

Obligation to sell:  If the buyer exercises the call, the seller is obligated to sell the underlying asset at the agreed strike price. Even if the market price is higher.

Uncapped loss potential:  If the asset price rises significantly above the strike price, the seller incurs large losses. The loss depends on how much the asset price exceeds the strike price.

Option expires: If the option expires unexercised by the buyer, the seller gets to keep the premium received. No further obligation.

Factors Determining Call Premium

The main factors that influence the premium pricing of call options are:

Underlying asset price – The higher the asset price, the higher the call premium since the chance of price rise increases.

Strike price – The lower the strike price compared to the spot price, the higher the premium as the intrinsic value rises.

Time to expiry – More time until expiry means a higher chance of price rise. So the premium is higher.

Volatility – Higher expected volatility of the underlying asset increases the call premium.

Interest rates – An increase in interest rates leads to higher call premiums.

Call Option Payoff

The payoff for call option holders at expiration is:

If underlying price > strike price: Profit = Underlying price – Strike price – Premium

If underlying price ≤ strike price: Loss = Premium paid

Due to the limited downside, the call buyer’s loss is restricted to the premium paid. The upside profit potential is theoretically unlimited. The seller faces exactly the opposite payoffs from short calls.

Key Uses of Call Options

Call options have many uses for traders and investors; some of the uses are mentioned below:

Speculation – Profit from the anticipated rise in asset price while risk is limited.

Hedging – Hedge against expected increase in asset price. Portfolio protection.

Leverage – Control large quantities of underlying assets by paying small premium amounts.

Diversification – Add call options to the portfolio for diversification and reduced risk.

Income – Earn steady income by selling call options to other traders.

As the trader can expect a return, there are chances of risk which might harm the trader.

Risk in Call Option

Expiry into worthlessness: If the price of the underlying asset does not move above the strike price by expiry, the call option becomes worthless, and the buyer loses the entire premium paid. This is the major risk for option buyers.

Unlimited downside:  For call writers or sellers, the potential losses are unlimited if the underlying price rises sharply above the strike price. This can lead to large losses.

Factors affecting value: Many factors like underlying price, volatility, and interest rates affect option premiums and can adversely impact the P&L for buyers and sellers.

Time decay: As the option moves closer to expiry, the time value component loses value. Buyers may see the premium paid erode with time.

Implied volatility changes: An increase in implied volatility increases call premiums, while a decline reduces premiums. This can impact value negatively.

Assignment risk: Call writers face the risk of early assignment if the option is deep in-the-money before expiry. This forces them to sell underlying assets below market price.

Incorrect directional view: If the market view or directional assumption is wrong, the call buyer stands to lose the entire premium amount.

Leverage risk: The leveraged nature of options can result in large percentage losses compared to the initial premium paid.

Liquidity risk: Illiquid options may have very wide bid-ask spreads and low trading volumes, making closing positions difficult.

Conclusion 

The call options offer buyers the right to buy assets at a preset price in the future. They allow profiting from a bullish outlook while capping losses. Sellers earn income by providing this right in exchange for premiums. Understanding call option mechanics is vital for many trading and hedging strategies. You can use the demat app to start trading in options trading. You can seek expert advice from Share India for any financial advice.

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