Buying A Call Option: Here's All You Need To Know | Espresso

Beginners Guide to Call Buying Options

Do you want to invest in the stock market but are concerned about the capital risk? Stop worrying. We have another solution for you, that is buying a call option. It will allow you to invest in stock while only spending a modest amount of money. 

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To learn about them in detail, check this article.

What Are the Call Options?

A call option is a trading strategy that gives you the right to acquire a stock at a certain price and time (before the expiration date). However, you are not bound to exercise your options here. 

But when you opt for exercising your call buying option, the amount you need to pay here is known as premium. The prime difference between regular stock investments and call options is that the latter has an expiry while the former doesn't.

Components of Buying a Call Option

  • Strike price

It refers to the price at which you can invest in the underlying stocks.

  • Premium

Premium refers to the option's price, either for the seller or the buyer.

  • Expiration

It is the period in which your option will either expire or be settled.

How Does the Call Options Work?

Buying a call option is profitable only if the pre-decided sum is less than the underlying asset's current market price on the day you exercise your options.

Here's an illustration to help you understand.

Assume you part in call option trading for XYZ for a month at ₹2500, for a price of ₹45. Here, you have the option to buy XYZ shares at the price of ₹2500 on the date the call option is executed. But, if on the settlement day, the XYZ stock price is ₹2300, executing your option will result in a loss. So, in this case, it is preferable to buy the stock on the open market.

What are Stock and Index Call Options? 

Stock options refer to calls on individual stocks. For example, you can exercise your buying options on HDFC, Tata Steel, Reliance, TCS, etc. On the other hand, index call options are used to invest in a certain index. The profit and loss of such options are determined by index value movements.

Benefits of Buying a Call Option

  • Call options are cost-effective. It's because you don't need high capital for investing in stocks as options are available by paying a small premium. 
  • Call options are not as volatile as other investment alternatives. Therefore, you can considerably reduce your investment’s risk if you manage it effectively. Moreover, even if you fail to exercise your option before expiry, you only lose the premium price. 
  • You can also generate additional income in the form of premiums through covered calls

Things to Consider Before You Choose to Buy a Call Option Strategy

  • Understand volatility 

Volatility is an important aspect in determining the option's value. When the market is extremely volatile, price swings in either direction are very likely. If the market moves in your favour, you make a decent profit. Whereas if it is against you, losses are on the cards.
Also Read: Volatity Index & Its Impact on Equity Market

  • Decode the time value behaviour

The premium price consists of time value and intrinsic value. For example, assume the call option strike price for the XYZ Ltd. stock is ₹1450. Then, the spot and premium prices are ₹1460 and ₹56, respectively. Here, the intrinsic value is ₹10( ₹1460 - ₹1450), and the balance of ₹46 is the time value. 

Knowing the premium component is vital because time value reduces over time. And on the date of expiry becomes nil. So it helps you understand the real worth of your investment.

  • Plan your strategy

Never rely on a single trade strategy if you want to mitigate the risk of investment. For example, if you expect the market to be volatile, choose a combination of Strangle and Straddle options. On the other hand, selling the strangle and straddle is recommended if you anticipate the market to be range-bound.

Other strategies that you may follow are covered calls and butterfly trading options.

  • Hedge your risks

Call options provide you with flexibility that you can use to mitigate your risk. For example, assume you have specific stocks in your portfolio. But given the current market conditions and some major events, you are concerned that prices would decrease sharply for a short time. Here, you can consider purchasing a put option to mitigate the risk.

  • Strike price selection 

Many investors place trade into extremely low-cost options. It's because they have high anticipation of making profits as prices rise. Hence, they favour deep out-of-the-money strikes. Unfortunately, if you are doing the same thing, your chances of getting price levels over the strike price are minimal until the market takes a major swing. Therefore, it is recommended to go for a slightly out-of-the-money or at-the-money strike price.

Conclusion

Buying a call is an effective way to increase your portfolio's exposure to different assets. Moreover, you don't have to place a large amount of capital to trade in this investment strategy. 

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Frequently Asked Questions

As a call buyer, you could lose up to the amount of the call premium you paid. In basic terms, your total loss is equal to the seller's total profit.

Investing in highly volatile stock can be a risky affair. Assume the stock you have bought never trades above the strike price. In this instance, your call option may expire without being exercised. If you believe in the stock's fundamentals of a firm and are optimistic about it, you should buy stock rather than a call option.

The first disadvantage, or rather, problem, is finding the perfect strike price and expiry time. You don't want to end up in a situation where your underlying stock never trades above the strike price before the contract expires. Another drawback is time decay. Since call options have an expiration date, their value decreases over time.