Basics of Derivatives
What is a Call Option?
A call option is an options contract in which the buyer has the right to buy a specified quantity of the underlying stock at a predetermined price without any obligation.
Now let us understand this with an example:
Let us assume that a stock is trading at ₹100 today.
And today, you are getting the option that gives the right to buy the same stock one month later, at the same ₹100, even if the shares trade more than or less than ₹100.
So, should you buy it?
The answer is yes, as this means that even after one month if the share is trading at ₹120, and you can still buy it at ₹100.
To get this right you need to pay a small amount today, say ₹5, which is called the premium amount.
Now, if the share price goes above ₹100, then you can exercise your right and buy the shares at ₹100. If the share price stays at or below ₹100 then you do not need to buy the shares. You just lose ₹5 which you had paid for the right to buy in this example.
This type of options contract is known as the 'Call Option.'
What are Long Call Options?
When the traders expect that the price can move up, or when they are bullish- then they can take a long position in the call option.
Traders need to pay a premium in order to buy a call option. They buy these options due to the expectation that the underlying price will increase.
But if the price drops below the strike price, then the option holders lose the amount paid for the premium. This happens because the contract will not be exercised by the buyer, and hence it will lapse.
For example, let us assume that you are bullish on a stock. You buy a call option with the strike price of the stock is ₹5000 and the premium which you pay is ₹70.
Premium is the maximum amount that a buyer will agree to suffer as a loss. If the price of share increases, the buyer exercises his option.
If the share’s price does not increase beyond the strike price of ₹5000, then the option expires on the maturity date. The buyer thus incurs a loss of ₹70 on the premium.
From the above diagram, you can see that your profits will be unlimited if the price moves up and losses will be limited to the premium.
What are Short Call Options?
The short call options involve selling an option of a given underlying asset at a predetermined price.
This strategy leads to limited profit if shares are traded below the strike price, and it attracts substantial risk if it is traded at a value more than its strike price.
From the above diagram you can see that when shorting a call option, the profit is limited to its premium amount that is ₹70 and the loss is unlimited.