What Is Call Option? Learn the Basics

A Call Option is a type of futures contract falling under the derivatives category. It gives the person "the right to buy an underlying asset" before the expiry date, but "it's not an obligation or compulsion." In short, you can exercise your call right and buy the asset. But you can also deny doing so. That's the power of a call option.
So, why do people go for call options?
Let's consider the earlier stock example. If you believe the company's stock price may rise by 5% in the next month, the chances of you buying it today stay. But the probability of that event happening can be anything. So, you enter into a call option where you pay a premium and buy the right to buy this stock in the future at a fixed price.
Now, if the stock price touches 5%, you can exercise (fulfill) your call option and buy the stock at the set (futures) price. However, in the reverse scenario, if the stock price didn't move as desired, you can decide not to exercise (fulfill) the option contract. But, this right is only applicable before the expiry date.

Basic Terms and Conditions in a Call Option

In options contracts (both call and put), there are common terms and conditions you should know.

1. Strike Price - The price at which the option buyer can purchase the underlying asset. It's pre-decided at the time of entering the contract.
2. Premium - The amount the buyer pays to the seller (writer) of the option for entering the contract. It's like a charge/fee for holding that asset till expiry.
3. Expiry Date - The last date on which the option can be exercised. After this, the contract becomes invalid.
4. Lot Size - Options are traded in fixed quantities called lots. You cannot buy options in single units. For example, one lot of the Nifty 50 call option has 65 units.
5. In-the-Money (ITM), At-the-Money (ATM), Out-of-the-Money (OTM) - These terms indicate whether the option is currently profitable or not based on the underlying asset's price (or spot price).

Call options are derivative contracts traded on the exchanges. Here,there are two investors involved, where one assumes the asset will fall, and the other thinks it will rise. This asset could be a stock, index, commodity, currency, or other financial instrument.

So, if a person feels the asset price will rise in the near future, he will enter into an option contract with a predefined price (known as the strike price) and an expiry. An option contract will give the person the right to buy the underlying asset at the mentioned strike price. Also, the call buyer must pay a premium amount (like a fee) to the seller during the period.

On expiry, if the spot (market) price of the asset is above the strike price, the buyer makes a profit. But, in the reverse case, if the spot price is below the strike price, the maximum loss is the premium paid.

Here, the maximum loss for the call buyer is the premium paid. However, the maximum profit would depend on the level of the underlying asset price at the time of exercise/expiry of the contract.

Let's assume Mr. A holds an XYZ stock at ₹1200. He believes the price will rise by 3% (est ₹1236) in the next two months. So, to protect himself from this volatility, he buys a call with a strike price of ₹1230 with an expiry of 2 months. Also, he pays a premium of ₹130 on this option contract.

At expiry, the price of XYZ stock reaches ₹1250. Mr. A finds a positive opportunity and exercises his call right and buys the stock at the strike price of ₹1230. Here, the advantage to the buyer is that he saved ₹20 by not buying the same stock from the cash market at ₹1250.

How Is the Premium for Call Options Calculated?

Option premium is the fee (cost) paid by the call buyer to the seller. So, while it's an expense (cost) for the buyer, it acts as an income for the seller.

The premium of any option is made up of two parts:

Premium = Intrinsic Value + Time Value

Now let's break that down using this example:

1. Intrinsic Value(IV)

   For a call option,
   Intrinsic Value = Spot Price – Strike Price (if positive)
   If the result is negative, the intrinsic value is taken as zero.
   At the time Mr. A buys the option, the stock is at ₹1200 and the strike price is ₹1230.
   So,
   IV = 1200 – 1230 = –30 → Intrinsic Value = ₹0
   (It is OTM, so IV is zero.)

2. Time Value (TV)

   Time value represents the extra premium a buyer pays for the possibility that the price may move favourably before expiry.
   Since the intrinsic value is zero, the entire premium (₹130) is due to time value.
   Time Value = Premium – Intrinsic Value
   TV = 130 – 0 = ₹130

Two types of call options define the role of an investor. It includes Long Call and Short Call.

Long Call Option- When a person buys a call option with the right to purchase the underlying asset in the future, it is referred to as a "Long Call". However, the long call option buyer has no obligation to buy that asset.

Short Call Option- Whenever someone buys a call option, there is a counterparty who sells that call option. It is known as "Short Call Option."

The payoffs for Call options depend on the type of call taken. For example, a long call option buyer will have unlimited profits, but risk is limited to the premium paid. Likewise, for a short call buyer, the maximum profit is the premium received, while the loss can be unlimited.

Let us understand the call option payoff with an example.

In the above table, the breakeven point for the call buyer is ₹1,360. However, the call seller will start incurring a loss after ₹1360.

Call options have their own entry timings in the market. Investors may buy or sell a call depending on the following situation. For instance;

When Should You Buy a Call Option?

• When you expect the stock or index to move sharply upward.
• When you want limited-risk, high-upside exposure (loss capped at the premium).
• When you prefer to leverage instead of buying the stock outright.
• When you anticipate a breakout, news event, or bullish trend.

When Should You Sell a Call Option?

Traders can sell a short call option in two scenarios: a Covered call (when you already own the stock) and a Naked call (you own no stock).

If You're Selling a Covered Call

• When you expect the price to stay sideways or rise only mildly.
• When you want to earn a steady premium income on your holdings.
• When you're comfortable selling the stock if the strike is hit.

If You're Selling a Naked Call

In this case, you don't own the stock, so you sell a call when;

• When the investor is confident that the price will stay below the strike.
• When they want to earn a premium but also understand that there is high, unlimited risk involved.

Call options are a type of derivative contract that allow investors to buy an asset at a future price at a certain strike price. They also don't have an obligation to fulfill their right on expiry. As a result, this tool is viable in situations when a bullish signal is expected. However, proper research and knowledge are necessary to trade in options or any financial instrument.