What is a Call Option?
Chances are that at some point, you have either been involved in a real estate transaction or know someone who has purchased a property.
Now, think back to that transaction.
Let’s assume this involved buying a flat costing ₹1 crore from the owner. You obviously did not pay the entire amount up front. Instead what you possibly did is pay, say, 5% of the cost, or what is commonly known as a ‘token.’ So, for a sum of ₹5 lakh, you now have rights to that property worth ₹1 crore. This allows you to buy it at a future date at the predetermined price of ₹1 crore.
Meanwhile, six months after you paid the token, the government starts work on a new metro line. The metro station is to be built right opposite your property. Demand for property in the area increases, as does the asking rate.
The market rate for the same property is now a neat ₹1,20,00,000 (1.2 crore). You, however, can still buy the property at the predetermined price of ₹1 crore. Say, instead, property rates crash. You could opt out of the deal. You will, of course, lose out on the token amount of ₹5 lakh.
A call option works in a similar fashion. Want to know more? Read on.
What is a Call Option?
A Call Option is a contract that gives the holder the right, but not the obligation, to buy the underlying security at a predefined price at a certain date.
There are a few key components associated with options: the underlying, the options premium or cost, the expiration date, and the strike price. There are few others but we will introduce those concepts later. We will get into more detail for each of these individual concepts but here is a quick overview and how they relate to the real estate example.
- Underlying and underlying price: The underlying is the security that the option is based on. This could be an index like the Nifty or Bank Nifty or one of the approximately 200 individual scrips that are optionable.
- Relationship to the example: The underlying is the rate of the property which in our example is ₹1 crore.
- Options premium or cost: When you buy a call option, you pay a certain amount - also known as a premium - to hold this option. This premium you pay can change moment to moment just like a stock or index would. This is because the price changes based on supply-demand dynamics: if more people are interested to buy, then the price will go up and vice versa.
- Relationship to the example: The options premium can be synonymous with the token you paid to buy the flat, i.e., ₹5 lakh. This will increase as the property price increases, and vice-versa.
- Expiration date: Unlike traditional assets, options have finite lifespans that are determined by their contract terms. When you are looking to purchase an option, you will be able to select from a range of expiration dates. After the expiration date, the option no longer exists. Weekly expirations typically occur on Thursdays and monthly expirations typically occur on the last Thursday of the month. We will discuss more about expiration dates in another chapter.
- Relationship to the example: This is where things differ significantly. In a property transaction, one has to complete payment of the entire amount on the day when you take the keys to the property - on possession.
Let’s look at an example to better understand call options as they relate to the financial markets. Assume the Nifty is currently trading at 17,600. If you believe that it will go up in value in the next 2 weeks, you could either buy the Nifty for 17,600 or buy a call option - which would cost you far less. There is a call option available expiring in 2 weeks that will provide the option holder value if the Nifty moves up in price from 17,600. This call option costs ₹200 which is only 1.1% of the price of the Nifty.
Note here though, that while the call option is cheaper to purchase, it has a limited lifespan. If you don’t turn a profit with the call option in under 2 weeks, even after accounting for the cost to purchase the option, you will have a loss. If this is still a bit complicated, don’t worry, we will go into detail throughout subsequent chapters. Our intent at this point is just to mildly expose you to these concepts.
- A Call Option is a contract that gives you the right, but not the obligation, to buy the underlying security at a predefined price at a certain date.
- A call option has a direct relationship with the underlying asset. If its price increases, so does the value of the call option.
- You pay a premium to buy an option. This can change by the minute, just like a stock or index.
- Contrastingly, the strike price is the price at which you exercise the option. It is related to the price of the underlying security or index.
- The option is only valid till its date of expiry, after which it ceases to exist.
Put options are the polar opposite of call options. You can read more about it in the next chapter.
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