A call option is a type of options contract that gives the buyer the right, but not the obligation, to buy an underlying asset at a predetermined price, known as the strike price, on or before a specified date.
Traders buy call options when they expect the price of the underlying asset to rise. The concept of a call option is similar to paying a small amount to reserve the right to buy something at a fixed price in the future.
For example, a builder is selling a flat for ₹50 lakh. A buyer believes property prices may rise, but is not ready to purchase the flat immediately. The buyer pays ₹50,000 to reserve the right to buy the flat at ₹50 lakh within the next six months.
This arrangement is similar to a call option:
| Real estate example | Call option |
|---|---|
| Flat | Underlying asset |
| ₹50 lakh | Strike price |
| ₹50,000 reservation amount | Premium |
| Six-month reservation period | Expiry |
If property prices rise and similar flats are selling for ₹55 lakh, your reservation becomes valuable because it gives you the right to buy the flat at ₹50 lakh.
If property prices fall and similar flats are selling for ₹48 lakh, you can choose not to buy the flat and lose only the ₹50,000 reservation amount.
A call option works similarly. The buyer pays a premium for the right to buy an asset at a fixed price while limiting the maximum loss to the premium paid.
How do call options work?
When a trader buys a call option, they pay a premium for the right to purchase the underlying asset at the strike price.
If the price of the underlying asset rises, the value of the call option may increase because the right to buy the asset at the strike price becomes more valuable.
The buyer can then choose to sell the option or exercise it, depending on the contract specifications. If the price of the underlying asset remains below the strike price, the option may expire worthless. In that case, the buyer's maximum loss is limited to the premium paid.
Example
Suppose Reliance Industries is trading at ₹1,500.
A trader expects the stock price to rise and buys a call option with:
- Strike price: ₹1,550
- Premium: ₹30
The trader pays ₹30 for the right to buy Reliance at ₹1,550 until expiry.
If Reliance rises to ₹1,650, the call option is likely to become more valuable because it gives the trader the right to buy the stock at ₹1,550 while the market price is higher.
The trader can either:
- Sell the option and book a profit, or
- Exercise the option, subject to the contract specifications.
The breakeven price for this trade is:
Breakeven = Strike Price + Premium
₹1,550 + ₹30 = ₹1,580
This means the stock must rise above ₹1,580 for the trade to be profitable at expiry. If Reliance remains below ₹1,550 until expiry, the option may expire worthless, and the trader loses only the premium paid.
Why do traders buy call options?
Traders may buy call options to:
- Benefit from an expected rise in the price of an asset.
- Gain exposure to price movements with a smaller upfront investment than buying the asset directly.
- Use leverage to potentially amplify returns.
- Limit downside risk to the premium paid.
What are the risks of buying call options?
Some risks include:
- The option can expire worthless if the expected price move does not occur.
- Time decay can reduce the option's value as expiry approaches.
- The underlying asset may not move enough to offset the premium paid.
- Options can be highly volatile, resulting in rapid changes in value.
A call option gives the buyer the right to buy an underlying asset at a predetermined price. Traders use call options when they expect prices to rise because they provide upside exposure while limiting potential losses to the premium paid. However, traders should understand factors such as premiums, breakeven prices, and time decay before trading call options. To learn more about call options, visit the Call Options basics module on Varsity.