What is Call Writing?
The securities market has several options for investors to choose from. Whilst shares and debentures are the most commonly known securities; the relatively lesser-known derivatives are also dynamic securities. One of the major types of derivative contracts is an options contract.
What is an Options Contract?
An options contract is a type of derivatives contract which confers upon the option holder the right to purchase or sell the underlying asset at a preset price on a pre-decided date in the future.
It is important to understand that an options contract only offers the buyer the right to buy or sell the underlying asset as per the terms of the contract, not an obligation to do so, and the buyer of an options contract is referred to as the options holder.
Also Read: What is Futures Contract?
What is Call Writing in an Options Contract?
There are several option writing strategies available for investors, one of which is call writing. Writing a call option, also referred to as call writing, is the process of entering into a contract to purchase or sell a certain underlying asset at a specific price on or before a specified date in the future.
Writing a call option makes the call writer obligated to honour the buy/sell contract if the option holder chooses to exercise the contract. In exchange for call writing, the call writer charges a sum which is termed as premium. This premium is one of the main driving forces for a call writer to enter into a binding buy/sell contract for a particular security.
If the option holder decides not to exercise their buy/sell option, the call writer retains the premium. Call writing options is, thus, an interesting strategy applied in the trading of derivatives. However, it is important to note that call writing options for shares are usually written in multiples of lots of shares, with each lot typically comprising 100 shares.
Also Read: Bear Put Spread Strategy in Options Trading
How does Call Writing in an Options Contract work?
Let us understand how call writing works with the help of an example. Trader A, who has 10,000 shares of Company X, decides to write a call option to offer the option buyer (Trader B) the right to buy the shares at a strike price of ₹10 each after three months.
After the period of three months expires, the option holder can exercise their right to buy the aforementioned shares at the predetermined strike price. As consideration for writing this call, Trader A charges a premium of ₹12,000.
If Trader B decides to exercise their option and purchases the shares at a strike price of ₹10, the options contract shall be considered completed. This is likely to happen if the market price of the underlying shares after three months is higher than the strike price of the options contract, that is, higher than ₹10. Exercising the buy option would, thus, be profitable for Trader B.
If, however, the market price of the underlying shares after three months is lower than the strike price of ₹10 as decided in the options contract, Trader B may choose not to exercise the option to buy. In such a scenario, Trader A'a profit from writing a call option shall be the premium of ₹12,000, and the same amount shall be Trader B's loss of buying the call option.
Benefits of Call Writing
There are several benefits of call writing, some of which have been mentioned below.
- The call writer receives an immediate income in the form of a premium.
- In the event of the options contract expiring, the call writer retains the premium amount without having to engage in any actual trading of the underlying asset.
- The call writer has the option to buy back the options they have written from the open market.
- Owing to the time decay associated with options contracts, the call writer enjoys a decline in their risk as the time to exercise the option draws nearer.
To Sum it Up
The options writing strategy of call writing is highly useful in the derivatives market. However, it must be applied only after careful consideration and thorough research
Also Read: What is covered call in Option Trading?
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Frequently Asked Questions
The major risk associated with writing a call option is the movement of the potential movement of the market price of the underlying asset in a direction that is not favourable to the call writer. This can happen in one of the following ways.
- When the call writer has written an options contract to sell an underlying asset and the market price at the time of the expiration of the contract (say ₹10 per share) ends up being higher than the strike price of the contract (say ₹8 per share), thereby leading to a loss for the call writer;
- When the call writer has written an options contract to buy an underlying asset and the market price at the time of the expiration of the contract (say ₹10) is lower than the strike price of the contract (say ₹12), it causes the call writer a loss.
By writing a call option, a call writer enjoys the benefit of the immediate receipt of a premium amount. This amount can be retained even if the options contract is not exercised by the option holder. Call writing enables a trader to benefit from a decreasing risk due to the time decay of options contracts. Furthermore, there is a significant amount of flexibility associated with call writing since the call writer can buy back their options from the open market should they so desire.