BASICS OF CALL OPTIONS AND HOW IT WORKS !!!

How exactly do options work? We have all heard of call and put options and options trading. But how to trade options and what are the key features of options trading in India. Let us first understand what call options is and then let us get deeper into call options with an example.

What is a call option?

Options are financial contracts drawn on an underlying asset, which can be stocks, commodities, or currencies.

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

A call option is a right to buy without an obligation to buy. So if you have a call option on TCS then you have the right to buy TCS but no obligation to buy TCS at a pre-determined price. For example, if you have bought a TCS 1-month 3540 call option at a price of Rs.20. On the settlement day if the price of TCS is Rs.3700, the option is profitable to you. But if on that date the price of TCS is Rs.3200 then you are not interested in buying TCS at 3540  when you can buy it in the open market at Rs.3200. For this right without obligation you pay a premium of Rs.20, which will be your sunk cost.

A call option will have a strike price, which is the specific price quoted for the underlier in the contract and expiration date. Like in the above example, the strike price of TCS shares is 3540, and the expiry date is 1-month. To purchase a  call option, you need to pay an amount to the seller/writer, called a premium. If you choose not to exercise the call option, the seller gets to retain the premium, which in that case will be his profit. If the call option holder decides to exercise the right in the contract, the seller is obligated to sell the underlier at the strike price.

The opposite of a call option is the put options. Put options give the options holder rights to sell an underlier at a strike price at a forward date. Both call options and put options trade in the Indian market. Now let's understand options trading in India.

Key Takeaways

- Call options are financial contracts that give the holder rights to buy an underlier 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 

- A call option becomes premium when the price of the underlier moves upward in the market 

- The market price of the call option is called a premium. It is determined based on two factors: the difference between the spot  and strike price of the underlier and the length of time until the option expires

- Call options are bought for speculations and sold for income purposes  

Understanding option trading in India…

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. Call options will be available in near-month, mid-month and far-month contracts. Remember, all call option contracts will expire on the last Thursday of the month.

What are Index call option and stock call options?

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, Bank Nifty calls etc. Stock options are options on individual stocks. Thus you have call options on Reliance Industries, Tata Steel, Infosys, and Adani SEZ etc. The principle of trading call options in both cases is the same. You buy call options when you expect the price of the stock or index to go up.

What are a European Call Option and an American Call option?

Before understanding European and American call option, let us first understand the concept of exercise of call option. When you buy a call option, you have two choices in front of you. Either you can reverse a call option (sell if you have bought it and buy if you have sold it) in the market or you can go to the exchange and exercise the 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.

What are weekly call options and what are monthly call options?

Monthly call options are the normal options that expire on the last Thursday of the month which are popularly trading. 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 in the recent past.

What are ITM and OTM call options?

This is a very important classification when it comes to options. In-the-money (ITM) call options are those where the market price is higher than the strike price. The Out of the money (OTM) call option is one where the market price is lower than the strike price. If market price of Infosys is Rs.1707, then 1850 Call Option will be ITM while 1500 Call Option will be OTM.

When it comes to call options, what is time value?

The option premium, as we saw earlier, is the price that the buyer pays to the seller for getting the right to buy without the obligation to buy. This option premium has 2 components viz. time value and intrinsic value. The intrinsic value is the price profit while the time value is the probability that the market is assigning to the option becoming profitable. All ITM options will have intrinsic value and time value while OTM options will only have time value.

Can we understand this with a call option example?

Assume that Infosys is quoting at Rs.1700. Let us look at various scenarios of call option strike prices.

Strike Price	Premium	Expiry	ITM/OTM
1680 Call	35	Jan-2018	ITM
1700 Call	24	Jan-2018	ITM
1720  Call	14.5	Jan-2018	ITM
1740 Call	9.10	Jan-2018	ATM
1760 Call	6.25	Jan-2018	OTM
1780 Call	4.90	Jan-2018	OTM

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

What influences the price of the call options?

There are various factors that influence the price of the call option. Of course, the strike price and the market price are very important factors. Political events that add to uncertainty and volatility in the market may also push up the time value of call options and therefore the price of these options. Similarly, if interest rates are cut then it increases the present value of the strike price and reduces the gap between the strike price and the market price. Thus it will be negative for call options.

A Guide To Call Buying Strategy

Buying call options is a good trading strategy, but it requires an understanding of buying a call option. Traders buy call options when they are bullish on an underlying because it allows them to leverage. Let's try to understand the situation with the help of an example. 

Let's assume stocks of Reliance Company is selling at a spot price of RS 2600. Now, you want to buy 100 shares of the company anticipating it to remain bullish. If you're going to buy the stocks, you will have to invest RS(2600*100) or Rs 260000. Or, you have the option to buy call options at Rs 3000 (Rs 3*1000). You can own 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 Rs 3000 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. 

With the call option, you can also close your position and exit trade. Continuing with the above example, if you find close to 1 month that shares are trading at Rs 550, you can sell the call options and make a profit of Rs 2000. Here is how. 

Price of shares Rs 550*100 = 55000

Initial Market price Rs 2600*100 = 260000

Premium paid = Rs 3000

Total profit = (55000-50000-3000) = Rs 2000

Trading calls is a useful option strategy to increase your market exposure without infusing lots of funds.

As we have seen, options trading in India offer a good way to participate in the markets with limited risk..