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Understanding How Call Options Work

Explore what call options are, how they function, and why traders use them in stock market strategies.

Call options are financial contracts that grant the buyer the right—without any obligation—to purchase an underlying asset at a predetermined price before a set expiration date. Commonly used in options trading, they serve as useful instruments for both risk management and profit opportunities. Knowing how call options function can help investors navigate market movements strategically, whether for portfolio protection or potential gains.

What Is a Call Option

A call option is a contract between a buyer and a seller that gives the buyer the right to purchase an underlying asset at a pre-agreed price (called the strike price) on or before a specific date (called the expiry date).

The seller of the option, also known as the option writer, is obligated to sell the asset if the buyer wishes to exercise the option. The buyer pays a premium for this right.

Key Terms in Call Option Trading

To better understand how call options work, it's important to become familiar with a few core terms:

Strike Price

The predetermined price at which an option holder is entitled to purchase the underlying asset.

Premium

The cost paid by the buyer to the seller to acquire the call option contract.

Expiry Date

The final day by which the option holder must exercise their right to buy or sell the underlying asset.

Lot Size

Options are traded in lots, and each lot represents a specific number of shares of the underlying asset.

In-the-Money (ITM)

When the market price of the asset is higher than the strike price.

Out-of-the-Money (OTM)

When the market price is lower than the strike price.

How Call Options Work in Practice

Call options offer an opportunity to gain exposure to a stock without needing to purchase the shares outright.

Example:

An investor purchases a call option on Stock X:

  • Strike price: ₹100

  • Premium paid: ₹5

  • Lot size: 100 shares

  • Expiry date: 1 month from purchase

Scenario 1: Stock X rises to ₹120

  • Investor profits ₹15 per share (₹120 - ₹100 - ₹5 premium)

  • Total gain = ₹1,500 on investment of ₹500

Scenario 2: Stock X stays at ₹100 or falls

  • Investor does not exercise the option

  • Loss limited to ₹500 (premium paid)

This feature of limited loss and potentially unlimited gain is what attracts many to call options.

When Are Call Options Used

To Speculate on Price Increase

Traders buy call options when they expect the price of the underlying stock to rise. It allows them to participate in upside movement with limited downside.

To Hedge Existing Short Positions

If a trader has sold a stock short, buying a call option can limit potential losses in case the stock price rises.

As Part of a Larger Options Strategy

Call options are often used in combination with other options (e.g., covered calls, bull call spreads) to create structured strategies that align with the trader’s market view.

Types of Call Options

Call options are typically categorised based on how and when they can be exercised.

Type

Description

European

Can be exercised only on the expiry date

American

Can be exercised at any time up to and including the expiry date

In Indian markets, options traded on the NSE (National Stock Exchange) are generally European-style.

Factors That Affect Call Option Prices

Several factors influence the premium (price) of a call option:

Underlying Asset Price

Higher stock prices increase the value of call options, especially those close to or in the money.

Time to Expiry

The more time remaining, the more valuable the option — known as time value.

Volatility

Higher market volatility increases the likelihood of the option moving in-the-money, raising its value.

Interest Rates

Rising interest rates may increase the premium slightly, particularly for longer-dated options.

Risks and Considerations

While call options offer a leveraged way to bet on price movements, they carry specific risks:

  • Time Decay: Value reduces as expiry approaches, even if the underlying stock doesn’t move.

  • Premium Loss: If the stock doesn’t move as expected, the entire premium paid can be lost.

  • Liquidity Risk: In some contracts, lack of trading activity can make it difficult to exit the position early.

Call options require careful risk management and a clear understanding of the strategy being employed.

Conclusion

Call options are powerful financial instruments that allow traders to take a bullish stance on a stock or index with limited upfront investment. Whether used for speculation or risk management, they provide flexibility in structuring positions, but require careful understanding and disciplined use. However, traders should ensure they fully understand the mechanics and risks before entering the options market.

Disclaimer

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.

FAQs

What is the maximum loss in a call option?

The maximum loss is limited to the premium paid for the option.

Yes, call options can be sold in the secondary market any time before expiry if liquidity permits.

No. Buying a call option gives you the right to buy the stock but doesn’t require ownership beforehand.

Yes, major indices like Nifty 50 and Bank Nifty have actively traded call options.

If you don’t exercise the call option before expiry and it is out-of-the-money, it expires worthless and you lose the premium paid.

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