What Do You Mean by Selling/Writing A Call Option?
The number of participants in the Indian stock markets has grown swiftly in the last two to three years. A large volume of investors entered the market after the COVID-19 pandemic. As per a report by the State Bank of India (SBI), a whopping 142 lakhs new retail investors joined the stock markets in India in the financial year 2020-21.
Investors who have just started investing in these markets usually invest in the cash segment or equity shares and believe it to be the entire stock market. However, the stock market ecosystem is much larger than this. For example, apart from the cash segment, there is a derivatives segment that allows investing in the derivative products of stocks, commodities, bonds, and currencies.
Futures and Options (FnO) are the two most common stock market derivative products. You can invest in Futures and options to hedge against your losses in other asset classes and make high returns in short periods. In this article, we will discuss a phenomenon known as “writing a call option”, which is a fundamental part of investing in derivatives.
But first, let’s learn what options and call options are.
What are Options?
As mentioned above, options are derivative products that deal in stocks or shares of companies. They are legal contracts between the two parties wherein the buyer of the contract gets the right but not the obligation to buy or sell a specific quantity of stocks at a specific price on or before a pre-determined date in the future.
Depending upon your trading strategy and prevailing market conditions, you can exercise your options contract, let it expire, or sell it again.
The Two Types of Options Contracts
As you know, the price of a stock can either fall or rise. Trading in options allows you to make money by speculating the price movements of stocks in the short term. As per your speculations and technical analysis, you can buy an options contract to either sell or buy a specific quantity of stocks at a specific price on or before a specific future date.
Based on whether an options contract provides the right to buy or sell underlying stocks, they are of two types:
- Call Options
A call option gives you the right but not the obligation to buy a specific quantity of underlying stocks at a specific price (known as the strike price) on or before a pre-determined date in the future. You should buy a call option if you think that the price of its underlying security will rise in the future.
A call option is profitable only if the price of the underlying security is higher than the strike price at the time of expiry. However, since a call option doesn’t obligate you to buy the underlying security, you can choose to not exercise it if it doesn’t seem profitable at the expiry.
- Put Options
A Put Option is exactly the opposite of a call option. It gives you the right but not the obligation to sell a specific quantity of underlying stocks at a specific price on or before a pre-determined date in the future.
A Put Option is profitable if the price of its underlying security remains lower than the strike price at the time of expiry. Needless to say, you should buy a Put Option only if you think the price of the underlying stock may fall in the future.
What is the Meaning of Writing or Selling a Call Option?
Now that you know what options and the types of options are, let us tell you the meaning of writing or selling a call option. As you know, options trading involves two parties, i.e., the one who buys the options contract and the other who sells the options contract. A person who sells a call option is known as a call writer or seller, and a person who buys a call option is known as a call buyer.
A call buyer needs to pay a premium to the call writer to buy a call option. The call writer needs to formulate the call option or contract by specifying the strike price, premium amount, and expiry date. This process of formulating a call option or selling calls is known as writing a call option.
The call writer and the call buyer stand at two opposite ends of a call option. It means that in case the Call Buyer wishes to exercise their call Option and sell the underlying securities, it’s the call writer who will need to buy those securities at the strike price of the contract.
So, a call buyer will gain only if the price of the underlying security rises, and a call writer will gain if the price of the underlying security falls. In other words, if a call buyer makes profits, the call Writer will suffer losses and vice versa.
Also Read about Covered Call
By now, you must have understood the options trading phenomenon, different types of options, and the significance of writing or selling a call Option. However, if you want to trade in options, you need to remember that just like the cash segment, the derivative segment in the stock markets also entails certain risks. Although call Writers have more chances of making profits, you need to take your decision based on detailed research and market analysis.
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Frequently Asked Questions
You should write or sell a call option only when you think that the price of a stock will not rise above the strike price till the expiry of the contract. In other words, you should write a call option if you’re bearish about a stock in the short term.
When you write or sell a call option, you receive a premium from the call buyer. This premium is the maximum profit that you can make out of the contract, given that the price of the underlying stock doesn’t rise above the strike price before expiry. Note that the profit in call writing is limited, but losses are unlimited.
You can write a call option only if you’re an options trader. You can write a Call Option using an underlying stock and defining its strike price, premium amount, and the expiry date. Then, you can sell your call options in the derivatives market to earn a profit.