0 Call Option



Definition:
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration). For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.

Buying Call Options

Call buying is the simplest way of trading call options. Novice traders often start off trading options by buying calls, not only because of its simplicity but also due to the large ROI generated from successful trades.
A Simplified Example
Suppose the stock of XYZ Company is trading at Rs40. A call option contract with a strike price of Rs40 expiring in a month's time is being priced at Rs2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid Rs200 to purchase a single Rs40 XYZ call option covering 100 shares.
Call Option Payoff Diagram


Say you were spot on and the price of XYZ stock rallies to Rs50 after the company reported strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, your call buying strategy will net you a profit of Rs800.

Let us take a look at how we obtain this figure.

If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ stock at Rs40 each and can sell them immediately in the open market for Rs50 a share. This gives you a profit of Rs10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is Rs1000.

Since you had paid Rs200 to purchase the call option, your net profit for the entire trade is Rs800. It is also interesting to note that in this scenario, the call buying strategy's ROI of 400% is very much higher than the 25% ROI achieved if you were to purchase the stock itself. This strategy of trading call options is known as the long call strategy.

Selling Call Options

Instead of purchasing call options, one can also sell (write) them for a profit. Call option writers, also known as sellers, sell call options with the hope that they expire worthless so that they can pocket the premiums. Selling calls, or short call, involves more risk but can also be very profitable when done properly. One can sell covered calls or naked (uncovered) calls.

Covered Calls

The short call is covered if the call option writer owns the obligated quantity of the underlying security. The covered call is a popular option strategy that enables the stockowner to generate additional income from their stock holdings thru periodic selling of call options. See our covered call strategy article for more details.

Naked (Uncovered) Calls

When the option traders write calls without owning the obligated holding of the underlying security, he is shorting the calls naked. Naked short selling of calls is a highly risky option strategy and is not recommended for the novice trader.

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