What is a Call Option?

Introduction to Call Options

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?

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 flat and the underlying price is the current price of the flat, which is ₹1 crore. Its value could go up or down in the future.

• 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. The value of the token amount will fluctuate with the market value of the flat.

• Strike Price: This is the predetermined price at which the holder of the call option will have the right to purchase the underlying security for.

Relationship to the example: The ₹1 crore is the strike price. You can buy the flat at ₹1 crore even if the value of the property rises.

• 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: The token we purchased for the property doesn’t last forever. At some point, we have to make the decision to buy the flat or let the token expire.

Now, 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 22,500. If you believe that it will go up in value in the next two weeks, you could buy a call option. Say, a call option is available expiring in two weeks that has a strike price of 22,500 and costs ₹225. If the Nifty moves up by more than ₹225, the cost of the call option, on expiry in two weeks, you will be profitable.

Note here though, that while the call option only costs a small amount, it has a limited lifespan. If you don’t turn a profit before the option expires, you will have a loss.

Put options are the polar opposite of call options. You can read more about it in the next chapter.