What Is Call Option And How It Works?

When you first begin investing, all the different terms that you are bound to make an acquaintance with will confuse you. The wide range of financial instruments available for investing into the Indian market will stump you with the plethora of opportunities that seem available to you, but this is why it is necessary to first learn from the basics and then invest.

The different investment instruments differ on a range of parameters, but mainly focused on their risk profile. While government securities, debt instruments and fixed deposits are extremely safe investment instruments which offer guaranteed returns and no risks; there are other financial instruments such as equities or related contracts which are slightly more complicated in terms of their risk profile. In most cases, however, the higher the risk profile of an investment instrument, the more returns it will be capable of generating. Among one of the first terms that will make an appearance as you delve further into studying the market is the option contract. This financial contract between two parties is usually based on the value of an underlying asset, such as a stock or a security.

Options can be of several types, but call options are among the most prominently traded options in the financial markets.

What Is Call Option?

If you have always wondered what is a call option, then you need look no longer. A call option is a contract wherein you win the right, but not the obligation, to buy a certain stock at a decided upon price on a date that is mutually decided between the contracting parties.

Since there is no obligation on the need to make the purchase as dictated by the call option, you need never execute it unless it is profitable to you. The purchase can only be profitable if the previously decided upon amount is lesser than the price of the stock on the date that the call option is meant to be executed. This pre-determined price of the stock is called the strike price. Unless your strike price is lesser than the price of the stock on the date of execution, you will end up bearing losses through the call option.

If you are still trying to grasp what is call option, let us understand with an example. For instance, if you enter into a call option for TCS for a month at 2700, for a price of Rs. 45; you have the option for buying TCS stock at the price of Rs. 2700 on the date the call option is to be executed. However, on the settlement day, if the price of TCS stock is Rs. 2500, then exercising your call option would be a loss for you since you could have purchased the stock in the open market for a lesser price. On the other hand, if the price of TCS stock on settlement day is Rs. 2900, you stand to make a profit by exercising your call option. In order to attain this right to buy the stock without any obligation to buy, you have paid a premium of Rs. 45, which will be your sunken cost.

What Is Put Option?

Put option works exactly opposite to the call option. Whereas the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the strike price on the date agreed upon by the contracting parties.

The market is constantly focused on analysing whether there are more put options being bought or call options, since this information goes a long way in determining the market sentiment. If more put options are being bought than call options, it may signal a rise of bearish sentiment in the market, since more traders are looking to sell their assets.

In a bid to keep track of such developments in the market, factors such as the put call ratio take on unprecedented importance.

Read more at How Does Put Options Work?

What Is Put Call Ratio?

The put call ratio is a metric which investors use to keep track of market sentiment. It is a measurement that is derived through division of the number of put options being traded by the number of call options being traded.

When the put call ratio is 1, it suggests that the number of buyers of put options are equivalent to the number of buyers of call options. However, since the market usually has a higher number of people buying call options as compared to the number of people buying put options, a put call ratio of 1 is hardly an accurate starting point. A good basis for evaluating positive market sentiment would be a put call ratio of .7, especially for the equity market.

Advantages Of Call Options:

As mentioned earlier, most investors prefer buying call options rather than put options. There are several reasons for that, especially since call options offer more benefits than put options. Read on to learn the advantages of buying call options.

1. Cost-Effective Investment:

Investing in the equities or similar investments can often require you to set aside a high amount of money in order to make the investment viable. However, by buying a call option, you are simply paying for the premium which is dependent on the underlying asset which is more affordable to buy. In this manner, you can invest through cost-effective means.

2. Lesser Risks:

Investing in the equity market is quite risky since market conditions can change overnight without anybody being any the wiser. However, investing in a call option is significantly less risky than investing directly into an equity or other instrument. The full extent of your losses on a failed call option is the nominal amount you pay as premium for the right to purchase the call option.

3. Earn Premium Through Covered Calls:

The market offers enormous opportunities for profits if you understand the market well enough to make use of these opportunities. Even after having bought a call option, you can generate additional revenue by selling the call option contracts. If the equity that you bought a while ago has appreciated in value, you can write a call option wherein the strike price is the current market value and earn a premium on it. In market lingo, this is referred to as covered calls and enables investors to earn additional profits.

Conclusion

If you had previously wondered what is call option, I hope your answers are clear enough. Before you rush off to buy the best call options though, make sure to thoroughly understand the market conditions and study the factors that are likely to cause an impact.