What are Call (CE) Options?

Disclaimer: Options trading is considered extremely risky, 9 out of 10 traders incur a net loss, please trade responsibly. See the SEBI circular for more details

This article assumes that you are familiar with options basic, If you are starting with options, make sure to check out our option primer.

What is a Call Option?

A Call option usually denoted by CE, is a type of contract between buyer and seller to buy a pre determined quantity of Shares at a pre determined price before or at the end of expiry.

For buyer, the contract provides option but no obligation to buy the stocks while for seller, there is an obligation to sell the shares. For providing this option, seller charges a “premium” for the option.

How does call option work?

In case of Call option, the buyer of contract has the option to buy the share at the strike price, which would only be beneficial if the current market price of underlying stock is higher than the strike price.

Example

Lets take example of 27th July Infosys (INFY) Call option for a strike price of 1340 which is closest strike price to current price, this is called an ATM (At The Money) strike.

So if I buy the CE option, and at the expiry date Infosys is trading at 1440, if I exercise the option, then I would need to buy 400 shares of Infosys from the seller of option at Rs 1340. This would mean I would have a take a loss of 100 per share and total loss of Rs 40,000, so it makes no sense for me to exercise this option, hence making this option worthless at expiry.

However if at expiry Infosys is trading at 1240, then if I exercise the option, the seller would have to sell 400 shares of Infosys to me at 1340 each, there by I would end up making Rs 100 profit per share.

Buying a Call option

If we plot the potential profit/loss of option as per price of underlying stock/index, we get a graph showing us the profit/loss at end of expiry. This graph is called a payoff graph.

The payoff graph for Infosys 1340CE options looks like this. Since seller of option is charging a “premium” for the option, the payoff does not exactly start at 1340, it would be at 1340 – premium, which at the time of writing is at 15.5, this makes the breakeven to 1355.5 (1340+15.5) at which point the payoff graph turns in to profit zone, denoted by green.

So a buyer would stand to make profit, if the stock price for Infosys is above 1355.5 at the expiry

Selling a Call option

In above example we looked from buyers perspective on what benefits it gives to buyer, now lets see why would someone sell a Call option.

A Call seller has an obligation to sell 400 shares of Infosys to the buyer, if he/she chooses to exercise the option, however as we saw it makes sense for option buyer to exercise the option only if the price of underlying stock is above 1340 (strike price). So if the Call seller is bearish on the underlying stock and if he/she is correct the option would expire worthless, thus earning the seller the premium.

Lets look at payoff graph from Sellers viewpoint

If the underlying price is below 1355.5 (1340+15.5) then the seller gets keep the premium which is 15.5×400 = 6200

However if the underlying stock price rises above 1355.5 then the seller would need to take losses. For seller the upside is limited to 6200 while the downside is unlimited.

How does Put premium change?

Options premium is determined by a lot of factors, but the Call option which is at or higher than underlying stock price would be more expensive than one which is far away from underlying stock price. i.e 1340CE would cost 15.5 while 1440CE cost only 1.45, 1240CE would cost 99.25. So the cost is directly proportional to the potential profit buyer would receive at expiry.

When to buy Call option?

1. If you are bullish about the underlying stock then buying a Call option is most profitable.
2. Risk is limited to loosing the premium only, there by the capital required is limited to only premium. This makes option buying very lucrative for traders with low capital.
3. If you buy a CE of strike which is away from current price of underlying stock, it would cost you very little money and market makes a sudden and large move towards your strike price, then the premiums rise very very fast. This would generate very high returns for option buyer in short term.

When to sell Call option?

1. If you are bearish about the underlying stock then selling a Call option can be good choice.
2. The premium of the option usually factors in the risk, ie. if 1340CE is exercised and current underlying is at 1440, the seller would loose 100 per share, but since the premium he/she receives is 99, the seller would still not loose anything.
3. Sellers usually combine the sale of Call option with other options to hedge risks.

Covered Call strategy

Lets assume you actually hold 400 shares of Infosys in your portfolio, in this case you could sell 1 lot of Infosys Call option at a strike above the current price of stock. This strategy is called Covered call strategy as it is covered by actual stock in your portfolio.

In case the share stays below the strike price, you get to keep the premium, where as if the stock rises above strike price, your portfolio stock would have covered the loss you would make on options. This allows you to get extra returns on your portfolio.

Conclusion

Put & Call options can be very useful tool for any trader buyer or seller, if used carefully. In most of the cases they can be combined with other options to form strategies based on your outlook of the market.