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Six things you must definitely know about a call option

Buying options may appear to be the easiest of trades to take up but there are a lot of nuances in buying of call options. Here are 7 things that you must know about a call option…

  1. A call options is a right to buy without the obligation

This is the most basic feature of a call option. The buyer of the call option gets a right to buy a stock or the index without the obligation. On the other hand, the seller of the call option has the obligation to sell the stock or the index without the right. For getting this right without the obligation the buyer of the option pays an option premium (option price) to the seller of the option. When you trade these options you are basically trading in these rights. When the price of SBI is Rs.250 then a call option with a strike price of Rs.255 may be available for Rs.3. This Rs.3 represents the value of the right for the buyer of the option.

  1. A call option is a wasting asset

What do we understand by a wasting asset? In India stock and index options are available in 3 contracts viz. near month, mid month and far month. The contracts typically expire on the last Thursday of the month. The option value is a value for the right without the obligation. As the date of expiry approaches this value of this right keeps gradually reducing. In fact, as the option expiry date approaches, the value of the option starts falling drastically. In the above case, if the price of SBI is Rs.250 then the value of the Rs.255 SBI call option will approach 0 as the contract approaches the expiry date.

  1. Value of a call options has two components

This is a very important aspect of options that traders need to understand. Let us understand this with the example of 3 different strike call options of the same stock for the same expiry. Let us assume that the stock price of Tata Steel is Rs.651. Let us look at the break-up in value of 3 different types of options of the same expiry…

Particulars

Rs.630 Call (ITM)

Rs.650 Call (ATM)

Rs.670 Call (OTM)

Option Price

Rs.29

Rs.10

Rs.4

Intrinsic Value

Rs.21

Rs.1

Rs.0

Time Value

Rs.8

Rs.9

Rs.4

As we can see in the above instance, the in-the-money (ITM) call has intrinsic value and time value while the OTM option has only time value.

  1. Call options are positively impacted by market price and volatility

The relationship between the various variables and the value of an option is captured by the Black Scholes model. The market price obviously has a positive relationship with the call option. If Reliance CMP is Rs.920 and the Rs.925 call is quoting at Rs.12, then if the CMP goes up to Rs.925 the option will obviously go up. What about volatility? Volatility means the stock is likely to see violent fluctuations which could be on either side. If it is against the buyer then the maximum loss is anyways capped by the premium. If the volatility is favouring the buyer then the option will be profitable. That is why volatility is always favouring the call option value.

  1. Call options are negatively impacted by strike price and dividends…

There are 2 factors that negatively impact the value of a call option. Let us look at the strike price first. When it comes to a call option, the low strikes will always be more valuable than the higher strikes. So as you move lower down the strikes, you see the value of the call option increasing. Then what about dividends? One can argue that option holders do not earn dividends. But stock holders do and dividend payments reduce the stock price and therefore reduce the value of the call option.

  1. When you sell a call option, your margins are like in the case of futures

Buying a call option is quite simple from the margining perspective as you only have to pay the premium margin. But when you sell a call option, there are a variety of margin payments. Firstly, there is the initial margin to be paid when you sell a call option. If the price of the stock goes up then the short-call position goes against you. In that case, there is also mark-to-margin that is payable. When you have sold a call option your margining liability is exactly like in the case of futures.

The best use of a call option is to hedge or protect your risk when you are short on the stock or you or short on futures.

How exactly does this work?

Existing Position

SBI at Rs.220

SBI at Rs.255

SBI at Rs.290

Short on SBI Futures at Rs.253

Profit on short Futures – Rs.33 (253-220)

Loss on short Futures – Rs.-2 (253-255)

Loss on short futures – Rs.-37 (253-290)

How to hedge

Loss on the Call Option– Rs.-3 (premium)

Loss on the Call Option – Rs.-3 (premium)

Profit on Call option – Rs.+32 (290-255-3)

Buy SBI 255 Call at Rs.3

Net profit / loss

Net profit / loss

Net profit / loss

Max risk = Rs.5

+Rs.30

Rs.-5

Rs.-5

As can be seen in the above case the maximum loss on the hedge is limited to Rs.-5, irrespective of how high the price of SBI goes. That is the power of hedging with a call option.

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