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Call Option Explained: A Step-by-Step Guide for Beginners

A call option is a derivative contract that gives a right to a buyer, to buy an underlying asset at a pre-determined price (called the strike price) having a pre-determined quantity (called lot size) on a pre-determined later date (called maturity or expiry date). However, it does not obligate the buyer to do so.

On the other hand, a seller of a call option contract has an obligation to sell the underlying asset if the buyer exercises his right to buy the underlying asset.


This right to the option buyer comes with a price (called option's premium) that a buyer of a call option contract has to compensate the seller at the initiation of the contract.



Example

On 25Jan2022, A entered into a call option contract wherein he has a right to buy the underlying asset, currently trading at $1488.05, at a strike price of $1490.00 on 27Jan2022. The initial premium paid is $8.72

The primary objective of entering into this contract is that A is expecting the asset price to rise above the 1490-level by the end of the option period. If the underlying asset's price closes above the 1490-level on the expiration date (say at $1500.00), then A can exercise his option to buy the underlying asset for $1490.00.


"option buyer gets the right, not the obligation"


If the price of the underlying asset closes below the 1490-level on the expiration date (say at $1480.00) then A is not obligated to buy the underlying asset for $1490.00 instead A can purchase the same from the market at $1480.00. In such a case, the call option contract lapses and the option seller will forfeit the initial premium of $8.72 received.


Observation-1: It depends on the moneyness of an option whether to exercise the right or not to exercise it. If a call option is trading "in-the-money", the option should be exercised.


Suppose, on the expiry date, the price of the underlying asset happens to be [$1498.05, $1508.05, $1518.05, or >$1508.05]

A will exercise his right to buy the underlying asset at the strike price of $1490.00 and the seller is obligated to fulfill it. A has already paid the option premium of $8.72 at the initiation of the contract. Therefore, the effective cost of buying the underlying asset turns out to be $1490.00 + $8.72 = $1498.72

It also means that the maximum the option seller can realize from the sale of the underlying asset is $1490.00 + $8.72 = $1498.72


After exercising the right, if A is not interested in having the underlying asset then A can sell the underlying asset in the market at the price prevailing on the expiry date. If the prevailing asset price happens to be as per below, the profit realization would be in line.


Observation-2: Once the contract is entered, the maximum that A can lose is the initial premium paid of $8.72


Suppose, on the expiry date, the price of the underlying asset happens to be [$1478.05, $1468.05, $1458.05, >$1478.05 or remains at 1488.05]

A will not exercise his right to buy the underlying asset at the strike price of $1490.00, rather A can purchase the same from the market at the reduced price. A has already paid the option premium of $8.72 at the initiation of the contract. Therefore, the maximum that the buyer can lose is the initial premium paid of $8.72

It also means that the maximum the seller can gain is the initial premium received of $8.72


If A is interested in having the underlying asset then A can purchase the underlying asset from the market at the price prevailing on the expiry date. If the prevailing asset price happens to be as per below, the loss realization would be limited to the initial premium paid of $8.72


Observation-3: The choice is indifferent between exercising the right to buy the underlying asset at the strike price or not exercising it if the price of the underlying asset happens to be equal to the strike price on the expiry date.


Suppose, on the expiry date, the price of the underlying asset happens to be $1490.00

Ignoring the qualitative factors, A is indifferent in choosing whether to exercise his right to buy the underlying asset at the strike price of $1490.00 or not to exercise it as the effective cost of buying the underlying asset will turn out to be $1490.00 + $8.72 = $1498.72 in both the choices.

Therefore, the breakeven point for the buyer is $1498.72


Observation-4: Assuming that the asset is not required for immediate use, entering into a call option contract instead of buying the underlying asset will (1). provide leverage; paying a small premium amount to have an exposure on the underlying asset (2). limit the losses that the underlying asset may incur, but that is the next topic of our financial book.


Use Cases of Call Options in the Financial Market

  • One common use of call options is to hedge against market increases. By purchasing call options, an investor can protect their portfolio against potential losses in the event that the underlying asset increases in value.

  • Call options can also be used to generate income through the sale of call options. When an investor sells a call option, they collect a premium from the buyer in exchange for the obligation to potentially sell the underlying asset at a later date.

  • Call options can also be used to speculate on market movements. For example, an investor who believes that the price of an underlying asset will increase in the future may purchase call options as a way to profit from the potential price increase.

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