What is Call Writing Options in Stock Market?
The participation of retail investors in the Indian stock market has grown rapidly in the last few years. Thousands of new investors are entering the stock market diaspora every month to grow their wealth.
As per the two depositories – the Central Depository Services (CDS) and the National Securities Depository Limited (NSDL) – approximately 286 lakhs new Demat accounts were opened between April 2021 to November 2021.
Investors who have just entered the market usually look to invest in the cash segment only through equity shares and mutual funds. However, investors who have been there for a long time can invest in the complex yet profitable derivatives segment. Trading in derivatives allows them to make large profits by hedging against the asset classes and speculating market movements.
This article is all about one such derivatives product known as “Options”. We will tell you about Options trading in detail and introduce you to the concept of call writing in options trading. So, let’s get started.
What is Options Trading?
Options trading involves buying or selling options contracts in the stock exchanges. Options are stock derivative instruments that provide the right, but not the obligation, to the buyer to buy or sell a specific quantity of underlying stocks at a pre-determined price and on or before the expiry date. Options contracts are legally binding documents with clearly defined terms and conditions.
Options trading is more flexible since it does not force the buyer to go through with the contract, as is the case with Futures trading. You have the option, but not the obligation, to exercise your Options contract any time before its expiry. In case the price of your underlying stocks falls below the contract price, you can limit your losses by paying only the premium for the Options contract.
Let’s understand this with the help of an example. Suppose you’ve purchased an Options contract to buy 2000 shares of a company at ₹500 each within a month. Now, if the price of these shares goes up to ₹700 within a month, you can buy them at ₹500 as per your contract and make a profit of ₹4 lakh. However, in case the price of these shares falls and remains below ₹500, you can pay the premium to the contract seller and refrain from buying the shares to limit your losses.
Two Types of Options Contracts
There are two types of options contracts:
- Call Options
These contracts give the right, but not the obligation, to the buyers to purchase a certain quantity of shares at a pre-determined price (known as the strike price) on or before the contract’s expiry date. Exercising a call option is beneficial only when the price of the stock is more than the strike price at the time of expiry.
- Put Options
These contracts are exactly the opposite of the Call Options. They give the right, but not the obligation, to the buyer to sell a certain quantity of shares at a predetermined price on or before the contract’s expiry date.
Also Read: Covered Call in Option Trading
What is Call Writing in the Stock Market?
When a buyer of the call Options makes a profit by exercising their Options contract, someone has to make losses. It is this call writer that suffers the losses in this case.
Call writing means the procedure through which a seller sells a call option to a buyer. So, when the buyer of a call Option exercises their right to purchase underlying stocks, the seller or call writer is obligated to sell the stocks. Similarly, if the buyer of the contract refrains from buying the underlying stocks and pays the premium, it’s the call writer who receives it and makes profits.
It means that if the buyer of the call Options makes gains, a call writer at the other end suffers losses and vice versa.
Advantages of Call Writing
Let’s learn about the advantages of writing call options:
- Profit through premium
When a buyer of a call Option decides not to exercise their contract, they need to pay a premium to the call writer. This premium is non-refundable and hence, results in profit for the call writer.
- Less risky
The call writing strategy is less risky than the call buying strategy. It’s because the call writers are mandated to receive the premium irrespective of what the call buyers choose.
Call writers have equal flexibility as call buyers. They can shut their open contracts any time before the expiry date, given that the buyer agrees. They can even sell the contracts at a higher price and then buy them back at a lower price.
The call writing strategy can be an excellent technique to protect yourself from both sides of transactions in the derivatives market. You can make good gains by selling call options to call buyers and wait for them to either exercise their contract or pay the premium.
Additionally, the buyers of call options are exposed to greater risks than call writers. But if you are diligent and smart enough, you can try your hands at Options trading and make handsome profits.
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Frequently Asked Questions
Writing a call option means selling someone an Options contract which gives the buyer the right to purchase the underlying stocks from you at a predetermined price on or before the expiry date. You are also required to sell the stocks to the buyer if they decide to exercise their contract.
When you write a call, you give the right to someone to buy a certain quantity of stocks from you at a certain price on or before the expiry date. However, in case the buyer doesn’t wish to purchase the stocks from you, he or she needs to pay you a premium which will be your profit.
The premium in call Options is the amount that the buyer of the Options contract needs to pay to the call writer for buying the contract. In other words, it is the price that someone needs to pay to buy an Options contract.