What is a Call Option?

A call option provides the buyer a right, but not an obligation, to buy an underlying asset such as stocks, bonds, or commodities. It is bought at a pre-determined strike price within a given time period. A call buyer may capitalise when the price of the underlying asset rises because of positive news about the company or mergers and acquisitions, whereas the seller may profit through the premium if the price falls below the strike price at expiry. A call option can be contrasted with a put option, which gives the holder the right to sell the asset at a specified price on or before expiration. This article explains what call option is, how it works, and its example. 

Call Option Example 

Call options can be understood through practical examples that demonstrate how these contracts work in real market scenarios. The following are some call option examples: 
 

• Buy Call Option: Assuming ABC Company stocks are currently trading at Rs. 100 per share, Investor C, holding 100 shares, seeks additional income beyond dividends. With expectations that the stock price won't exceed Rs. 120 next month, C explores call options and finds a Rs. 120 strike price call option trading at Rs. 0.40 per contract. C decides to sell one call option, receiving a premium of Rs. 40 (Rs. 0.40 x 100 shares). If the stock price rises above Rs. 120, the option buyer may exercise their right, obligating C to sell the shares at Rs. 120 each. However, if the stock price remains at or below Rs. 120, C will retain ownership of the shares without executing a sale. 
   
• Long Call Option: Let's say ABC company stock is priced at Rs. 50 per share. Investor Z buys a call option with a strike price of Rs. 55 that expires in one month, expecting ABC's price to rise to Rs. 55 by then. This call option gives Z the right to buy 100 shares of ABC at Rs. 55 each. If the premium for the option is Rs. 2 per share (totaling Rs. 200 for 100 shares), that's the maximum amount Z could lose. If ABC's price climbs to Rs. 60 by expiration, Z can buy shares at Rs. 55 and immediately sell them at Rs. 60, making a profit of Rs. 5 per share. But if ABC's price stays below Rs. 55, the option expires worthless, and Z loses the Rs. 200 premium paid. 
   
• Short Call Option Let's say stock ABC is priced at Rs. 50 per share. Investor Y expects the price to stay below Rs. 53 in the next month. Y decides to sell one call option with a Rs. 53 strike price that expires in a month. By selling this option, Y receives a premium of Rs. 2 per share, totaling Rs. 200. If ABC's price remains below Rs. 53 by the expiration date, the option expires, and Y keeps the Rs. 200 premium as a profit. But if ABC's price rises to Rs. 55, the buyer of the call option may choose to exercise it. Y would then have to sell the shares at Rs. 53, even though they are worth Rs. 55, resulting in a loss of Rs. 2 per share. 

How Do Call Options Work? 

After understanding the call option meaning, let's understand how it works. It functions as a strategic financial instrument where investors take positions based on their market expectations: 

1. Options are a contract between two investors. One believes the price of an asset may decrease, and one thinks it may rise. The asset can be a commodity, bond, stock, or other investment instrument. 
2. The contract is an option (a choice) to purchase the asset at a specific price by a certain date. The date is called the expiration date (known as expiry), and the asset is called the underlying asset. The price is called the strike price, which is set by the contract seller and chosen by the buyer. 
3. An investor pays a fee to purchase a call option; this is called the premium. It represents the price paid for the option to exercise. If, at expiration, the underlying asset is below the strike price, the call buyer may lose the premium paid. 
4. The call option buyer may hold the contract until the expiration date to execute the contract and take delivery of the underlying. The investor may also choose not to buy the underlying at expiry or sell the options contract before expiration at the market price. 

Difference Between Call Option and Put Option 

The following table highlights the difference between a trading call option and a put option: 

Factors Influencing the Price of the Call Option 

Several factors influence the price of the call in share market: 

1. Rates of Interest: Higher interest rates may increase premiums. The logic is that buying a call option is more affordable than buying the stock outright. The amount not spent on the stock can remain in a bank earning interest, making the call option suitable when rates are higher. 
2. Intrinsic Value: This is the fundamental value of the option based on the difference between the underlying asset price and the strike price. In-the-money call options have positive intrinsic value, whilst out-of-the-money calls have no intrinsic value, directly affecting the premium. 
3. Greek Values: These are metrics that measure the sensitivity of the option price to changes in various factors like the underlying asset price (delta), volatility (gamma), interest rates (rho), and time to expiration (theta). 
4. Volatility: This reflects market expectations for future price movements of the underlying asset. Higher expected volatility leads to a higher premium, as it increases the chance of the option becoming profitable before expiry. 
5. Expiry: As the expiry date approaches, the time value of the option declines, lowering the premium. Options with a long time to expiry may have more potential for the underlying asset to move in the buyer's favor, which may result in a high premium. 

When Should You Buy a Call Option? 

The following are some scenarios when investors may consider buying a call option 

1. When Security Prices Increase Before Expiration: If a security's price increases before its exercise date, buying a call option may yield a profit to an investor. 
2. When There is a Rise in Security Value: If there is a rise in the value of a security, it can be bought at the strike price and immediately sold off at a high market price. 
3. When Waiting for Further Price Rise: Holders of call options may choose to wait to assess the possibility of a further price rise. The option is not exercised if the price of the security does not rise above the strike price. 
4. When Selling Options for Profit: The investor may also sell off options with an increase in securities price, which may enable the investor to make a profit without even having to pay for securities. 

 Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions.   

Conclusion

Call options provide investors opportunities to capitalise from anticipated price increases while limiting potential losses to the premium paid. Understanding the call option meaning, how these contracts work, and the various strategies, like buying long and short call options, enable informed decision-making in the share market. Factors such as intrinsic value, time to expiration, implied volatility, and interest rates influence call option pricing. Investors should carefully evaluate market conditions, their risk tolerance, and profit objectives before trading call options through a reliable stock market trading app.