Skill Sheet: What You Will Learn Here
- What is call option?
- Two sides of call options
- How do call options work?
- Understanding naked call and covered call
Now that we understand futures and contracts a little, it's time to know what is a call option. The meaning of call option or CE is a contract that gives the buyer (of the option) the right to buy, but not the obligation, the underlying asset at the predetermined price (known as the strike price), within a pre-decided time-frame (known as expiration). It should be noted that the option to buy or not to buy lies purely with the buyer. A trader usually buys a call option when he expects the price of the underlying to go up. When the buyer of the call option exercises his call option, the seller has no other option but to sell the underlying asset at the strike price. However, this can happen only when the call buyer exercises his right before the expiry period. Remember, a call option is bought or sold not just for speculative purposes but also sometimes as part of a spread or strategy.
A call option always commands a price, which is known as a premium. Thus, the premium is the price one has to pay to buy the rights that the call option provides. If on the date of options expiry, the value of the underlying asset is below the strike price, and the call buyer has not yet chosen his right, he will lose the premium paid on the call.
For example, you bought an August call option in Asian Paints on 8th July 2022 at the strike price of 2,900 for a premium of Rs 110. Then the prevailing price of the underlying was Rs 2,880. On 8th August 2022, the stock price reached Rs 3,460, and along with it, the price of the option contract also went up. Now you can exercise the right to buy the underlying as the ruling price is favourable to you. Alternatively, you can sell the call option which you had bought on 8/7/22 for the then prevailing premium of Rs 110, at the current premium, i.e., on 8/8/22, of Rs 570, thus making a profit of Rs 570-Rs 110 = Rs 460. On the other hand, if the price of the underlying goes down to say, Rs 2,800, you will incur a loss. This will be the profit of call seller/writer.
Two sides of call option
Like any other transaction, a call option also has two parties — call buyer and call seller, who is also called the option writer. Call writing means initiating a contract to sell an underlying at a specified price (known as the strike price) on or before a specified date (known as the expiry date). Unlike a call buyer, a call writer (or seller) is under an obligation to sell the asset at the strike price on the expiration date. In return, the call writer gets a premium (known as option premium) to write the contract. Option premium is determined by the factors like the current share price, volatility and expiration date. Though option writing is a risky business, with the passage of time, option premium declines due to time decay, with which liability and risk of the call writer decrease. Further, the call writer gets the option premium immediately after the contract is entered into. Also, this premium amount is non-refundable when the call buyer decides not to exercise his option. The call writer also has the flexibility to close the contract at any time before the expiration date by buying a call in the market.
On the other hand, for the buyer of the call option, total risk is limited to the premium paid for the option. At the same time, theoretically, his potential profit is unlimited. Thus, the limited risk of loss which is predefined and the unlimited scope for profit make option buying attractive. Another advantage of call option buying is the comparatively lower margin requirement. In the above example of Asian Paints, one lot size is 200 shares. If you have to buy Asian Paints in the spot market, you have to shell out Rs 576,000 (200 X 2,880). But the call option is available only for Rs 22,000 (200X110). While the spot price has gone up by Rs 580 (Rs 3,460-Rs 2,880), the option price (premium) has gone up by Rs 460 (Rs 570-Rs 110). Thus, in this case, the call option buyer was able to pocket nearly 80% of the gain in the price of the underlying (in the cash market) by investing less than 4% of the cost of the underlying.
Naked short call vs Covered call
A naked short call is one when the option writer sells the option contract without owning the underlying stock. Therefore, this call is also known as an uncovered call or unhedged short call. This is one of the riskiest options strategies, which the option writers use only when they are sure that the price of the underlying does not rise above the strike price at the expiration. While there is limited upside profit potential, a naked call theoretically exposes the option writer to unlimited loss potential. Though theoretically, the potential for loss is unlimited, an option writer under this method usually limits his loss by buying back the option well before the price of the underlying rises too far above the strike price by using a well-defined stop-loss strategy.
On the other hand, in the case of a covered option call, the option writer selling the call options owns an equivalent amount of the underlying security. Though the option writer covers the possibility of unlimited loss by owning the underlying, this type of transaction requires more investment (to sell options and buy underlying), which eventually reduces his return on investment. Usually, this kind of transaction is entered into by an investor who already owns the underlying (as a long-term investment) and wants to earn additional revenue by option writing using the idle stock.
There are several options strategies available that can be adopted and mastered over a period of time. However, one of the most common strategies is to keep the loss to the minimum by using an appropriate stop-loss. Stop-loss is usually based on the price movement of the underlying, which has to be strictly followed to minimise the loss. Discipline is the core of success in options trading.
Things to remember
- A call option (CE) is a contract that gives the buyer of the option the right, but not the obligation, to buy the underlying asset at the predetermined price (known as the strike price) within a pre-decided time frame.
- Premium is the price one has to pay to buy the rights that the call option provides.
- For the buyer of the call option, total risk is limited to the premium paid for the option.
- A naked short call, also called an uncovered call or unhedged short call is one where the option writer sells the option contract without owning the underlying stock. This is a very risky strategy.
- In a covered option call, the option writer selling the call options owns an equivalent amount of the underlying security. This is a safer option but requires more investment than that a naked call option.
- Discipline is the core of success in options trading.