Call Writing: Definition, Types, Advantages and Strategies
There has been a rapid increase in derivatives trading in India apart from stock market trading and mutual fund investments. Derivatives trading is ideal for investors with high-risk appetites and it offers diversification of portfolios as well as safeguarding or hedging it.
Derivatives are any financial instruments that derive their value from any underlying asset. Now, there are various types of derivatives such as options, futures, swaps, etc.
An options contract gives the buyer of the option the right but not the obligation to buy or sell the underlying asset at a specific price on or before the date of expiration. There are two types of options- call options and put options.
Now that you are aware of what options are, let’s get into the details of call writing options.
Call Writing Options: What is it?
In options trading, call writing is a trading strategy that allows an investor to sell off call options at a particular strike price in return for a premium.
Strike price is the set price at which an underlying security or asset can be sold or bought on the date of expiry. The end date after which an options contract is considered null or void is its expiry date.
If you are the investor who has written the call option, then you will have to collect your premium from the buyer. In call writing option, if the stock price goes up then the buyer can exercise his or her right to buy the asset at the set strike price that will lead to your loss. If the stock price doesn’t move up, you can make a profit to the extent of premium received.
Here’s an example for a clear understanding.
Let’s say that an options trader has a bullish outlook on XYZ shares which are currently trading at ₹1,500 for each share. But he thinks that it will not move beyond ₹2,000 per share in the near term.
He decides to sell a lot of XYZ shares at a strike price of ₹2,000 for a premium of ₹200. Let’s say the lot size is 100. So, in this case, the premium that he would get is ₹200×100= ₹20,000.
The breakeven point for the call buyer would be premium + strike price. So, 2,000+200= ₹2,200.
To find out if the trader would be losing money or earning a profit, let’s discuss some of the probable scenarios.
Let’s say that XYZ company’s shares are trading at ₹2,200 each.
Here, he will neither make a profit nor a loss as the spot price is now the same as the breakeven point. The calculation of the same is given below:
(Spot price- break even point) x lot size= (₹2,200 – ₹2,200)x100= 0
Let’s take another scenario. Suppose the company’s share price stood at ₹2,300 at the date of expiration. What would happen in such a case?
Since the spot price now stands above the strike price, the trader will have to suffer a loss. The loss will only be limited to the difference between spot price on the expiry date and its strike price.
So, his loss would stand at:
(Spot price – break even point) x lot size
= (2,300- 2,200) x 100
= 100 x 100
Let’s say that on the date of expiry, XYZ company shares are trading at ₹2,000.
Here, the trader’s assumptions did turn out to be correct. The spot price of the company stock did not go beyond ₹2,000 on expiry.
In this case, the total premium will be his profit.
Profit= lot size x premium =100x 200
Do note that the maximum profit in the call writing option will be the premium.
What are the various call writing options strategies?
If you are planning to opt for call writing options, here are some of the most commonly used call writing options strategies that you can follow:
- Naked call writing
In this strategy, you as a trader will write a call option despite not owning any underlying asset or stock. With this strategy, your chances of loss are maximum since the stock prices do not have any maximum limit up to which they can move up.
- Collar options
In this call writing options strategy, you would buy a put option while writing a call option. This put option will help you to hedge any losses that might come up due to the call option.
- Covered call
In this strategy, you would be writing call options of a company in which you have a holding. You can go for this strategy if you think that the price of an underlying stock might drop or stay at the same price level over a short period.
With a covered call, you can limit the loss but it may limit the chances of profit.
What are the benefits of trading in call writing options?
Trading in call writing options come with various advantages some of which are listed below:
- You as a writer of the call option will be receiving a certain premium amount when you get into the contract. This amount will not be refundable in the event the buyer does not buy the underlying securities.
- As a call options writer, you can benefit from flexibility. You have the liberty to close the contracts at any point before the date of expiration.
Factors which impact call writing options
- Volatility in stock price
A fluctuation in the stock price of a company might be a major factor which can impact options trading and call writing. If the volatility is higher, then the premium for call options can be higher. This is because high uncertainty would mean the price has a high chance of going in either direction.
- Prevailing market sentiment
The ongoing market sentiment is another major factor that can determine how successful your call writing option might be. Usually, if the market is bullish, call options are more expensive and hence better chances of big profits for the writer. Alternatively, if the overall market sentiment is bearish, call options are cheap and hence might result in low profits for the writer.
- Interest rates
The prevailing interest rates can impact stock prices which in turn might influence the success of call writing options.
- Movement trend of share price
The prevailing trend in stock price movement will also determine the success of call writing options. If the share price of a company appears to have an upward trend, premiums will be on the higher side. Naturally, a drop in stock price will lead to a lower premium.
If you are planning to get into derivatives trading, then call writing options can be an excellent way to hedge your portfolio. You can get to avoid losses through the premium amount even though the buyer decides against purchasing a contract. However, make sure to conduct thorough research to ensure higher profit.
Frequently Asked Questions
Q1. What is premium in call options trading?
Ans. In options trading, premium stands for the amount which a buyer will be paying to the one writing call options in return for the assurance of selling that underlying asset as per contract in case the buyer wishes to purchase.
Q2. How can I write call options?
Ans. As an options trader, you will be able to write call options contracts for any underlying security or asset. This contract will have a specified strike price, a date of expiration as well as quantity.
Q3. What is a put option?
Ans. In options trading, a put option will give a trader the right (not obligation) to sell a stock at the strike price within the expiry date of the contract. As a buyer, you have to pay a premium to the seller for this right.
Q4. What is spot price?
Ans. In derivatives trading, spot price stands for the prevailing price of an underlying security such as bonds, stock, commodities, etc. Immediate buying or selling of an asset is to be carried out at this price.