Call options are a kind of option that gets more valuable when the price of a stock goes up. These are the most well-known types of options. They let the owner lock in a price to buy a certain company by a certain date. People like call options because they can gain value quickly if the price of the stock goes up by a small amount. Traders who want to make a lot of money love them because of this.
What is a Call Option?
Call options are financial contracts that allow the buyer the right, but not the duty, to buy an underlying asset (such as a stock or commodity) at a defined price (the strike price) within a set time period. A call option is a bet that the price of the underlying asset will rise.
If the asset’s price climbs above the strike price before the option expires, the buyer can exercise it and purchase the item at the lower strike price, earning a profit. If the asset’s price remains below the strike price, the option becomes worthless, and the buyer loses the premium paid for it.
Call Option Example
Imagine you think that in the next month, the price of Reliance Industries Limited (RIL) stock will go up. There is a ₹2,500 strike price call option on RIL that you can buy. It will expire in one month. You can buy RIL shares at ₹2,500 even though the market price is ₹2,700 if the price of RIL stock goes up to ₹2,700 by the date the option expires.
After that, you can sell the shares at the market price and get 200 rupees back each. If the price of RIL stock stays below ₹2,500 by the end date, on the other hand, the option is no longer valid, and you lose the premium you paid for it.
How Call Option Work?
There are bets on whether the price of a stock will go up or down. You can buy a call option on stock if you think it will go up. You can buy the stock at the lower strike price and sell it at the higher market price, making a profit, if the price of the stock goes up above the strike price before the option ends.
You lose the money you paid for the option if the stock price doesn’t go up above the strike price. If you buy a lottery ticket, you might win a set amount of money, but if the stock price goes up, you win more.
Why Buy a Call Option?
For a number of reasons, buying a call option can be a smart move:
- Limited Risk: If you buy a call option instead of the primary asset itself, the most you could lose is the premium you paid for the option. There is no loss if the stock price doesn’t go above the strike price.
- Leverage: Call options let you control a bigger share of a stock without putting as much money at risk. If the price of a share of stock is ₹1,000 and you buy a call option with a strike price of the same amount, you can control the same amount of stock as 100 shares for a lot less money.
- For those who think the price of a stock will go up a lot in the next few days, getting a call option can be a risky way to make money from that rise.
- Hedging: You can also use call options to protect stocks you already have. For example, if you own stock and are worried that the price might go down, you can buy a call option to protect your gains or keep your losses to a minimum.
What’s Your Profit on Buying a Call Option?
If you buy a call option, your profit will depend on how much the underlying object is worth at expiration compared to the strike price. At expiration, you can buy the asset at the lower strike price if the price of the asset is higher than the strike price.
After that, you can sell the item for more money, making a profit. If the asset’s price is below the strike price at expiry, on the other hand, the option is no longer valid, and you lose the premium you paid for it.
To sum up, here’s how to figure out your return from a call option:
Profit = (Asset price at expiration – Strike price) – Premium paid
You’ve made money if the result is good. In that case, you’ve lost money.
Why Sell a Call Option?
You can make money by selling a call option, which is also called “writing a call option.” However, this approach is riskier than buying a call option. If you sell a call option, you are basically giving someone the right to buy the underlying product at a certain price.
Another reason someone might sell a call option is:
- Generating Income: If you sell a call option, you can get paid right away, even if the option isn’t taken.
- Neutral or Bearish Outlook: You can make money from the option bonus by selling a call option if you think that the price of the underlying asset will stay about the same or go down.
- When you have covered calls, you can sell a call option against shares of the underlying product that you already own. This plan can help you make extra money and keep you from losing money.
That being said, it’s important to remember that selling a call option is also riskier than getting one. You might have to sell your shares at the lower strike price even if you would have liked to keep them at the higher market price if the price of the underlying asset goes up a lot above the strike price.
What’s Your Profit on Selling a Call Option?
How much money you make when you sell a call option depends on how much the underlying asset is worth at expiration compared to the strike price.
If the price of the asset is less than the strike price when the option ends, it is worthless, and you keep the premium you got when you sold it. If the price of the asset is higher than the strike price at end, on the other hand, you may have to sell it at the lower strike price, even if you would have liked to sell it at the higher market price.
In short, here’s how to figure out how much money you made by selling a call option:
Profit = Premium received – (Strike price – Asset price at expiration)
You’ve made money if the result is good. In that case, you’ve lost money.
Call Options Vs. Put Options
| Feature | Call Option | Put Option |
|---|---|---|
| Definition | A contract that gives the buyer the right, but not the obligation, to buy an underlying asset at a predetermined price within a specified period. | A contract that gives the buyer the right, but not the obligation, to sell an underlying asset at a predetermined price within a specified period. |
| Profitable Scenario | Asset price rises above the strike price. | Asset price falls below the strike price. |
| Loss Scenario | Asset price remains below the strike price. | Asset price remains above the strike price. |
| Used For | Speculating on price increases, hedging long positions, and creating income. | Speculating on price decreases, hedging short positions, protecting against losses. |
| Buyer’s Position | Bullish (expects price increase). | Bearish (expects price decrease). |
| Seller’s Position | Bearish (expects price decrease). | Bullish (expects price increase). |
If you want to learn more about put options, you can also read this What is a Put Option?
Buying a Call Option Vs. Owning the Stock
| Feature | Buying a Call Option | Owning the Stock |
|---|---|---|
| Initial Investment | Lower (only the premium). | Higher (full purchase price). |
| Upside Potential | Unlimited. | Unlimited. |
| Downside Risk | Limited to the premium. | Unlimited (can lose entire investment). |
| Leverage | Higher (can control a larger position with less capital). | Lower. |
| Time Value | Option has an expiration date. | No expiration date. |
| Dividend Rights | No dividend rights. | Entitled to dividends. |
| Voting Rights | No voting rights. | Entitled to voting rights. |
What Is the Downside of Buying a call?
The main bad thing about getting a call option is that it has a time value, which means it runs out of time after a certain amount of time. You will lose the premium you paid for the option if the stock price doesn’t rise above the strike price before the end date. Another thing that happens is that the time value of an option goes down as it gets closer to expiration.
This is called “time decay.” In other words, you could lose money even if the stock price is going up if the option ends before the price hits the strike price.
