When you purchase a call option, you are given the right to buy something, not the duty. This indicates that you will only carry out the terms of an option contract if doing so would result in a profit.

If you can buy something but are under no obligation, you have what’s known as a “call option.” If you possess a call option on the stock, you have the right to buy TCS at a given price, but you do not have the duty to purchase at that price. Suppose you bought a TCS 1-month 2700 call option and paid Rs. 45 for it, for example.

This option presents you with profitable opportunities on the settlement day if the price of TCS is Rs.2850. You do not want to spend 2,700 for TCS when you can purchase it for 2,500 on the open market, but that is the price that TCS will be at on that particular day. Your “sunk cost” is the amount of Rs. 45 you must pay for the benefit of having no obligations.

Now, let’s see what the call option definition is!

What is a Call Option?

Call option means the buyer has the right to purchase a stock or financial instrument at the value within a specific period. The seller is bound to sell the security upon exercise of the buyer’s option. The option may be exercised at any moment before the stated expiry date.

Depending on how near the underlying security’s price the option strike price is and how lengthy the option’s expiry date is, the seller gets a purchase price for the opportunity. If the buyer has a chance to exercise the option before expiry economically, the option’s price is determined by how probable or unlikely it is that they will be able to do so. For the most part, options are bought and sold in 100-share bundles. For a call option buyer, profit is sought when the underlying asset price rises over the option’s strike price.

On the other hand, the seller of a call option is betting that the asset’s price will fall or at the very least never climb to the option strike/exercise price before it expires, in which case the money received for selling the option will be pure profit.

Also Read: What is Margin Funding?

It is not lucrative for option buyers to exercise the option if the price of the underlying securities does not rise beyond the strike price before expiry. The buyer will lose the amount of money they paid for the option. Buyers may financially exercise their contracts in situations when the underlying stock price increases above the option’s strike price.

This illustrates how an option on 100 shares of a stock for $30 might work. Suppose the stock price climbs from $28 to $40 before your option expires. You may then use your option to purchase 100 shares of the stock for $30, netting you a profit of $10 per share right now.

To calculate your net profit, multiply the number of shares you purchased by the current share price of $10 per share. In this case, a $200 call option would have yielded a net profit of $800 (100 shares x $10 each = $800).

If the underlying security’s price rises, investors may use their tiny investment to benefit, or they can use it to hedge against positional risk. In contrast to individual investors, corporate and institutional investors rely on options to raise their marginal income and protect their stock portfolios from market volatility.

Types of Call Options

There are two different kinds of call options basics.

Long call option:

This is a conventional call option in which the buyer may purchase a stock at some future strike price, but they don’t have to. This is a long call option. A long call allows you to buy a company at a lower price in the future. Long call options for a high-profile event, such as a company’s quarterly earnings call, may be purchased. A long call option’s earnings are infinite, but its losses are restricted to the amount of the option’s premium. Thus, even if the firm fails to fulfil market expectations and its stock price falls, the buyer of a call option will only be responsible for the amount of money they paid.

Short call option:

As its name suggests, a short call option is the polar opposite of a long call option. In a short call option, the seller agrees to sell their shares at a specific price in the future if the option is exercised. Covered calls are the most common usage of short call options when the option seller already owns the underlying stock. If the deal does not go their way, the call helps to limit their losses. For example, if the call was uncovered (i.e., they did not hold the underlying stock for their option) and the value increased significantly, their losses would be multiplied.

Buying and Selling Call Options

Because call options are derivative securities, their pricing is determined by the price of an underlying asset, such as a stock. You may acquire 100 shares of ABC any time before or on December 31 by purchasing the call option with a $100 strike price and an expiry date of December 31.

The option buyer may also sell the contract to another option buyer at the current market price before the expiry date. If the cost of the underlying securities does not change, the option’s value will decrease as it approaches its expiry date.

Buying a Call Option:

In the context of call options, the buyer of the option is known as the holder. The holder of a call option acquires it, believing the price will climb above the strike price before the option expiry date. The selling profits, less the strike price, premium, and any transactional costs linked with the sale, equals the profit received..” The buyer will not exercise the option if the price does not rise over the strike price. The buyer will lose the amount of the call option’s premium.

A call option contract with an expiration date of one month and a strike price of $40 is priced at $2 if ABC Company’s stock is trading for $40. ABC call options with a $40 strike price are purchased by the buyer for $200, believing that the stock’s value will climb over time. The buyer will get $800 in net profit and $1000 in gross profit if ABC’s stock rises from $40 to $50.

Selling a Call Option:

They sell call options in the anticipation that they would be worthless when they expire, known as writers. They profit by keeping the premiums (price) that customers have paid to them. Because of this, the option buyer’s profit will be reduced or even lost if the underlying security price increases above the option strike price. There are two methods to sell call options:

Covered Call Option

An option is covered if the person selling it owns the underlying stock. Additional revenue is generated by selling call options on the underlying equities, which helps to balance out any possible price decreases. Due to the option seller’s ability to give the option buyer with stock shares that he has previously acquired at a price lower than the option’s strike price, they are “protected” from losing their investment. Regardless of whether the stock rises to the option strike price, the seller will be shielded from any actual loss because of his ownership of the underlying shares.

Naked Call Option

When an option seller sells a call option without owning the underlying stock, it is known as a “naked call option.” A company’s price might rise at any time, and the option seller is not “protected” by holding its underlying shares, making naked short selling of options very dangerous.

To offer shares to a call option buyer, the naked option seller must acquire stock at market price to fulfil the option holder’s request. You lose money when you sell call options worth more than your stock’s current market value if your stock’s value is higher than your strike price. Most option dealers demand a hefty commission to compensate for potential losses.

Call Option vs Put Option

The polar opposite of one choice is the polar opposite of the other. Until an expiry date, a call option gives the holder the right to purchase the underlying stock at a specific price. On the other hand, you may sell a put option at a specified price until its expiration date to get the underlying stock’s current value. To exercise their right, but not their duty, a call option holder may purchase the underlying stock before or on the expiration date at the special price, whereas a put option holder may sell the stock at the same price.

A Call Option’s Purposes

The following are some of the reasons why investors utilise call options:

1. Speculation

When the underlying stock’s price rises, holders of call options may benefit from the increase in value while incurring just a fraction of the cost of purchasing actual stock shares. They’re a high-yielding, leveraged investment with no upper limit on earnings or losses (the price paid for the option). Call options are high-risk investments because of their high leverage.

2. Taking a chance

Call options are a standard hedging tool for financial firms like investment banks and hedge funds. An option opposite your position may assist you in minimising your losses on the underlying instrument, much as insurance does. It is possible to hedge short and long stock portfolios using call options.

Conclusion

While trading options might be hazardous, there are methods to do it prudently. In truth, options may reduce risks while enabling you to benefit from a stock’s gain or loss, provided they are handled appropriately. For those who still want to aim high, you can choose from plenty of platforms like Nuuu.