What Is a Call Option? – Meaning and Types
When researching options trading, you will come across terms called call and put options. Using these strategies is an excellent way to multiply the gains you can receive by taking advantage of an asset’s price fluctuations. Exercise of such options is also done to hedge your equity position against a sudden moment in the price of security
Keep reading to learn more about call options.
What Is a Call Option?
A call option is a financial contract that gives you the authority but not the obligation to purchase an underlying asset at a prefixed price on or before an expiration date. This asset can be anything from stocks, bonds, commodities, etc.
Let’s see an example for a better understanding.
Suppose you have purchased a 1-month call option of Company ABC with a strike price of ₹2500. The premium that you paid for the contract is ₹50.
Now, on the contract’s expiration date, if the stock price is ₹2800, executing the contract would be profitable for you. You can simply exercise the contract, get shares priced at ₹2500 each and sell them in the stock market for a profit.
However, if the stock price stays at ₹2200 on the expiration date, purchasing the underlying asset at ₹2500 wouldn’t be fruitful when it is already available for much less in the spot market. In such a scenario, you can let the contract expire worthlessly, as you are not obligated to execute it. The only loss you have to incur is the premium amount paid, which is ₹50.
What Are the Types of Call Options?
The types of call options available are as follows:
- Long Call
Long call is the most common type of option that you can use. It relies on an underlying asset’s price to rise beyond its strike price before the expiration date. To initiate this contract, you have to pay a premium; investors generally use this strategy when they anticipate a significant rise in asset value.
- Short Call
You can sell a call option if you anticipate a moderate fall in the value of an underlying asset. It is a bearish trading strategy; a short-call reaps a limited profit if stock is traded below the strike price
- Index Call
An index call option is a financial contract that gives you the right to purchase an underlying asset (index in this case) and make gains or losses based on the movement in its value. In India, index calls are available for Bank Nifty, Nifty Financial Services and Nifty
- Stock Call
In case of a stock call, it provides you with the right to buy an underlying stock and make a profit or incur losses depending upon its price movement. You can buy stock call options for shares of Indian company listed on the stock market. Although all the listed stocks are not traded in the F&O segment.
- Weekly Call
A weekly call option is a financial contract having an expiry date of one week. SEBI introduced this strategy to reduce the risks of options trading. However, it is only available for indices and not for individual companies Generally, in India, indices will have weekly expiry on Thursday
- Monthly Call
This is a call option that is valid for one month. They expire on the last Thursday of every month. It is a popular option among swing traders.
- ITM Call
In-the-Money call options, or ITM call options, are contracts where the asset’s current market value is more than its strike price.
Example – If an underlying asset’s current value is ₹2,000 and the call option’s strike price is ₹1,500, it is called ITM.
- OTM Call
Out of the Money call options is a financial contract where the underlying asset’s market value is lower than its strike price.
Example – If the underlying asset’s market price is ₹3,000, but the call option’s strike price is ₹4,000, it is called OTM.
- ATM Call
At the Money call options is a financial contract where the strike price of an option is equivalent or very close to the underlying asset’s price.
Example – If the underlying asset’s market price is ₹3,000, but the call option’s strike price is ~₹3,000, it is called ATM
What is Time Value in Call Options?
Time value is the probability that the market offers an option to become profitable. Along with intrinsic value, it is an important component of an option contract’s premium, which is the price that you have to pay for the contract.
For ITM call options, both time and intrinsic value affect its price. Alternatively, for OTM call options, there is only the time value. As time passes and the option nears expiry, time value works in favour of option writers and works against the option buyers.
When to Buy or Sell a Call Option?
Price fluctuations are a part of every investment. So, if you feel that the price of a security may increase within a certain period of time, purchasing a call option can be an excellent way to make a profit.
In case there is a rise in asset price, you can execute the contract, buy the underlying asset at a strike price, and sell it off as soon as the asset’s price appreciates. You may also wait for the price to rise further before selling your assets.
However, if the asset’s price does not exceed the contract’s strike price, the option won’t be exercised, and you will lose the premium amount. This situation can also occur in case the asset’s price drops to zero.
Hence, it is advisable for you to exercise the contract carefully.
Option trading is an extremely volatile, and habit-forming activity. You should first understand the basics and use them as a hedge against a position in equity. Generally, it is not advisable to take naked exposure in options. You can start with a small quantum, and once you are able to understand the factors affecting premiums, you can try with big amounts.
Frequently Asked Questions
What are the advantages of purchasing a call option?
Some of the advantages of buying call options are that they are cost-effective trading options, and you can earn additional income by selling the options contract in the secondary market.
What is the difference between a call and a put option?
A call option gives you the right to buy an asset on a predetermined date at a particular price without any obligations. In contrast, a put option offers you the right to sell an asset at a prefixed price on or before the expiry date without any obligations.
What are the risks associated with call options?
Some of the risks associated with call options are the chances of losing the entire premium amount and the underlying asset’s value declining below the strike price on its expiry date.
What happens when a call option expires?
When the call option expires, as an option holder, you can either sell the contract or let it expire worthlessly. Based on the market price, the option can be an in-the-money or out-of-the-money option on expiry.