What Is Call Option?

What Is Call Option?

Just like futures, options are derivatives contracts that derive their value from the underlying asset. Call option is a type of option contract traded in the Indian stock market.

Call option meaning

A call option is a derivatives contract that allows the buyer to benefit from an up move in the underlying. 

A call option buyer has the right to buy the underlying asset at a predetermined price, at a predetermined time. Similarly, the call option seller, also known as “writer”, has an obligation to sell the underlying asset at the predetermined strike price when the buyer of the call option exercises this option. 

Let’s understand this with the help of an example. 

Mr. Kumar goes to the showroom to buy a new car. He is told that the car will be delivered to him 6 months later as it is a new model. He is given the choice of either booking the car now at the current price of ₹25 lakhs by paying just the booking amount of ₹50,000 or buying it after 6 months at the market price prevailing at that time. The choice of locking the price today by paying a booking amount is exactly how a call option works!

Call option example

Let’s understand with the help of an example how to transact in a call option i.e. how to buy call options and how to sell call options. So pay close attention.

Reliance Industries (RIL) is currently trading at ₹2,800. Mr. Ponting, a trader, has a bullish view on it and thinks that the price of the stock will rise in the future. So, to make a profit, he decides to buy one lot of RIL call option of 2,800 strike price (the price at which the option shall be exercised) at a premium of ₹100 (the amount paid to buy a call option). The lot size of RIL’s options contract is 250 (options and futures contracts are traded in multiples of their lot size).

Remember: The call option price of Reliance Industries options will derive its value from the price of the underlying, which in this case, is the shares of Reliance Industries.

Let's first consider the call option buyer’s perspective.

Scenario 1: At expiry, RIL share price closes at ₹3,000.

Mr. Ponting's view turned out to be correct and the spot price moved ₹200 above the strike price. He stands to make a profit in this case. 

Profit=(Spot price - Strike price - Premium paid) * Lot size

= (₹3,000 - ₹2,800 - ₹100)*250

= ₹25,000

Mr.Ponting earned ₹25,000.

Scenario 2: At expiry, RIL is trading at ₹2,900

In this scenario, Mr. Ponting makes neither profit nor loss. This is because even though his view was correct and the stock price went up, it was only enough to recover the premium paid to buy the option. This point is known as the breakeven point. It is a point where trade neither results in a profit nor incurs a loss.

Profit= (Spot price - Strike price - Premium paid) * Lot size

= (₹2,900 - ₹2,800 - ₹100)*250

= 0

Mr. Ponting earned  ₹0. This is because the ₹2,900 mark is the breakeven point in this scenario. For the call options, it is calculated by adding the premium paid to the strike price.

Break-even point = strike price + premium = ₹2,800 + ₹100 = ₹2,900. 

Scenario 3: At expiry, RIL is trading at ₹2,500.

In this case, Mr. Ponting chooses not to exercise the call option as his view turned out to be incorrect. So, he loses his entire premium paid i.e. ₹100 per contract.  

Total loss = ₹100 (premium paid) x 250 (lot size) = ₹25,000

The premium paid to buy the option is the maximum loss the buyer can incur. 

Now, can you buy chocolates from a shop, unless the shopkeeper is selling it? No. 

In the same way if Mr. Ponting wants to buy a call option, then someone must sell it to him. 

So, let's understand the call option from a seller's perspective.

Mr. Malinga, a trader, has a range-bound outlook on Reliance Industries, which currently trades at ₹2,800. He thinks that the price of RIL will fall in the near term. To make a profit, he decides to sell one lot of RIL 2,800 strike price call option of the current month's expiry for the premium of ₹100.

Now, let's assume that the call option purchased by Mr. Ponting was sold by Mr. Malinga (call option seller).

In all the scenarios, whenever Mr. Ponting (buyer) chooses to exercise the option, Mr. Malinga (buyer) will have to oblige.

Scenario 1: At expiry, RIL is trading at ₹3,000.

In this case, Mr. Malinga incurred a loss as Mr. Ponting's view turned out to be correct and the spot price moved ₹200 higher than the strike price. 

Loss =(Spot price - Strike price - Premium paid) * Lot size

= (₹3,000 - ₹2,800 - ₹100)*250

= ₹25,000

Mr. Malinga incurred a loss of ₹25,000. Here, Mr. Ponting's profit is Mr.Malinga's loss.

Scenario 2: At expiry, RIL is trading at ₹2,900.

As discussed above, the ₹2,900 mark is the break-even point in this scenario, which is calculated by adding the strike price and premium. This point is the same for the seller and buyer. So, as it is for Mr.Ponting, Mr. Malinga’s profit is also zero.

Scenario 3: At expiry, RIL is trading at ₹2,500

In this case, Mr. Malinga's view turned out to be correct and the spot price moved ₹300 lower than the strike price. Here, Mr. Ponting's loss is Mr. Malinga's profit, i.e. ₹25,000. {₹100 (premium received)  x 250(lot size) = ₹25,000}.

The maximum profit of an option seller is the premium received by selling the option.

Payoff Schedule

RIL @ Expiry

(Buyer) Mr.Ponting's Net Payoff (₹)

(Seller) 

Mr. Malinga's Net Payoff

3200

75,000 -75,000

3100

50,000

-50,000

3000 25,000

-25,000

2900

0 0
2800 -25,000

25,000

2700

-25,000 25,000
2600 -25,000

25,000

2500

-25,000 25,000
2400 -25,000

25,000

Payoff Chart

(Buyer) Mr.Ponting's Net Payoff (₹)

(Seller) Mr. Malinga's Net Payoff

It is essential to remember that the derivatives in the stock market are a "zero-sum-game" – meaning that the position taken by seller and buyer are exactly opposite and therefore have an exactly opposite payoff. So, any profit derived by the seller is at the loss of the buyer and vice-versa. 

As seen in the above example, the call option seller (Mr. Malinga) has a bearish view of the stock. With this view, his profit is limited to the amount of premium received and the loss potential is high. Selling a call option in the market is also referred to as a short call.

On the other hand, the call option buyer (Mr. Ponting) has a bullish view. With such a view, his profit potential is high, and loss is limited to the amount of premium paid. Buying a call option in the market is also referred to as a long call.

Call Option

Seller

Buyer

Premium Received Paid
Outlook Bearish/Range Bound Bullish
Profit Limited to the premium received Potentially Unlimited**
Loss Potentially Unlimited** Limited to the premium paid
Action Obligation to sell Right to buy

Note:

  • Trading in call options is done for hedging purposes as well. Call options in share markets are financial instruments to protect the portfolio as they are traded on a wide range of assets, including currencies, commodities, stocks and indices.
  • Most active call options in the Indian stock market are of indices such as Nifty50 and Bank Nifty and they have both weekly as well as monthly expiry. 
  • To "exercise" means to call into effect the right to sell or buy the underlying security that is specified in the contract.
  • On Indian stock exchanges, derivative positions can be settled in cash or physically. Physical settlement is valid for stock derivatives contracts. 
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