Futures and options are part of a larger category called derivatives, which means they derive their value from an underlying asset. So a call option on the index will derive its value from the index and the call option on, for example, Reliance Industries will derive its value from the price of Reliance Industries.
Understanding call options
Let us start with a hypothetical example. An investor is expecting the price of Reliance Industries’ stock to go up by 10% in the next one month on the back of the sharp rise in Jio numbers.
Here are few perspectives an investor can have:
|You expect the price to go up||Why the broker suggests||How you look at it|
|Investor can buy the stock in equity market and sell when the target price is reached||This is very safe because the stock is in your demat account. You can hold on to the stock||Why should I lock up such a large sum in one stock? There must be a better way to do it.|
|Investor can buy the Reliance Futures and keep rolling it over till the target is achieved||This is a good idea because you only pay the margin in futures, not the full cost.||It is fine if the price goes up. But then what happens if the price goes down sharply?|
|Investor can buy a call option on Reliance and book the profits when the price goes up||Here, the loss is limited to the premium that you pay on the option but profits are unlimited||We take the risk of losing the premium, but if it is profitable, then unlimited gains await|
From the above table, the follow key features of a call option can be gleaned:
A call option is a right to buy an asset (Reliance shares in this case) for a fixed price and for a fixed time period. Once that period is completed, the option automatically expires and becomes worthless.
Call option is a right but not an obligation. This means that if you buy a call option, then you can make profits if the price goes up, but your loss is limited to the premium even if the stock plunges by 70%.
The buyer of the call option has unlimited profit potential and limited risk. The seller of the call option, on the other hand, has limited profit potential and unlimited risk.
How to initiate and close a call option position?
Call options can be traded on your normal trading screen. Call options of different strikes are available for different monthly contracts. All options contracts expire on the last Thursday of the month. Check out the snapshot below:
The above picture depicts the price of a Reliance 1,180 call option expiring on October 25, 2018, also known as the October contract. The closing price for the call option is Rs57.50 while the spot price is Rs1,201. You may wonder as to why the right to buy RIL at Rs1,180 should quote at Rs57.50 when the stock price is Rs1,201. Should the call options not quote at a price of Rs21 (1201-1180)?
This brings us to the most important aspect of call options: time value vs. intrinsic value.
Time value vs. intrinsic value in call options
In the above snapshot, the RIL 1,180 call is quoting at Rs57.50. Of this, Rs21 is represented by the intrinsic value of the option. The balance Rs36.50 is represented by the time value of the option.
What is time value?
This is the value that is assigned to the option based on the probability that the stock could move higher. What will happen to the time value if RIL’s stock stays stagnant at Rs1,201 till the end of the month? The time value will gradually keep diminishing; by the day of the monthly expiry on October 25, the time value would have diminished from Rs36.50 to nearly zero; only the intrinsic value would remain on the day of the contract’s expiry.
How are profits or losses booked on call options?
Broadly, there are two ways to book profits in call options. You can either exercise the option on the expiry day or you can square up the option in the market. When you exercise the option, you get the difference between the (market price of the stock and the strike price of the option). This method is not very popular as it is now essential to take delivery on exercise of stock options.
The more popular method is squaring off call options. In this case, you can buy the RIL call option at Rs57.50. if the price of RIL goes up sharply, the price of the call option will also move up to, say, Rs72.50. You can just square the call option and book the profit of Rs15 here.
It looks so simple, then what is the catch?
Is making money through call options really so simple? The answer is ‘No’. There are two things you need to remember.
Firstly, the option sellers are normally the big traders and institutions who are much smarter and better informed. Hence, the percentage of option buyers making money in the markets is less than 10%. Secondly, options are priced to perfection. Call options tend to factor in most of the positives well in advance, and therefore, your chances of finding a really profitable call option is quite low.
Having said that; call options are a safer and methodical way of participating in the upside of the stock, subject to proper option valuation techniques.