Options Trading for Beginners: Understanding Call Options with Real-World Examples
In the world of stock market trading and investing, options trading is very popular which allows traders to speculate, hedge or even generate income without owning the underlying stock. Call options and put options are very famous and popular options among traders and investors who believe that the price of a stock, index or other asset will rise or fall. This guide will explain what a call option is, how it works, and how you can use it as a beginner.
What is a Call Option?
If we talk in simple language, option trading is a method by which we can trade a stock at a lower price without owning the stock or index. When traders think that the price of a stock or index will rise, they buy call options, which can potentially give them a profit. The buyer pays the premium upfront, which is the price of the option. If the price of the stock or index does not exceed the strike price before the expiry date, the buyer’s potential loss is limited only to the premium paid, while the profit is unlimited. If the price moves upwards then we can get the profit before the expiry day and we do not need to wait till expiry.
Types of call options:
In the world of options trading, it is important to understand the types of call options. These are often classified based on the relationship between the strike price and the current market price.
- In the money:When the strike price of the option is less than the current market price of the stock. This means that the option has intrinsic value and can be exercised profitably. This is also called the ITM option which has both time value and intrinsic value.
- At the money: When the strike price of the option is equal to the current market price of the stock. In this case there is no intrinsic value but the option can still have a great move and value depending on the future prospects. This is also called the ATM option.
- Out of the money: When the strike price of the option is higher than the current market price of the stock. This option has no intrinsic value, but its value can increase even if the stock price rises. But the movement in this option will be slow. It is also called the OTM option.
Why Do Traders Buy Call Options?
There are many reasons to buy a call option:
- Speculation: If traders expect that the price of a stock or an index such as Nifty 50 will rise then they buy call options to make more profits.
- Leverage Potential: With options, traders can control a large number of shares with a small initial margin. This magnifies the potential profit if the stock price moves favourably.
- Hedging: Traders and investors can protect their existing holdings from potential losses by selling call options.
- Flexibility: Call options allow traders to profit from fluctuations in stock prices without requiring them to own the stock directly.
- Diversification: Call options are a cost-effective way to diversify a portfolio. Traders can use options on different stocks and sectors, thereby spreading the risk without committing large amounts of capital.
How do call options work?
The call option offers the buyer less risk and more profit potential. If the stock price rises, the buyer makes a profit, and if the price does not rise, his loss is limited to the premium only.
- Paying a premium: The buyer purchases a call option by paying a premium, which can be his maximum loss.
- Profit potential: If the stock price goes above the strike price, the buyer benefits. He can either sell the option or buy the stock at a lower price and sell it at the market price.
If the price remains below the strike price, the buyer has no need to exercise the option, and his loss is limited to the premium only.
Example: Suppose you think that TCS stock, which is currently trading at ₹4,000, will rise next month. You buy a call option with a strike price of ₹4,100 and pay a premium of ₹50, with a lot size of ₹175, i.e. you will have to pay a total of ₹50*175= ₹8750, which will expire next month.
- Case 1: The price moves above the strike price, i.e. if TCS stock reaches ₹4,300, your call option will become in-the-money.
The profit will be = (Market Price – Strike Price) – Premium
(₹4,300 – ₹4,100) – ₹50 = ₹150 per share
You will get ₹150 points per share
Your total profit-
Total points you earned*Lot size of the stock
150*175=26250
This is the power of option buying.
- Case 2: Price remains below the strike price
If TCS stock remains at ₹4,000 or falls, your option will expire out-of-the-money.
In this case, the option will expire at 0 and your loss will be limited to the premium (₹50 per share) only.
Risks of buying a call option
While call options offer unique advantages, they come with risks that traders should carefully consider:
- Loss of premium: If the option expires out-of-the-money, it expires worthless, and the trader loses the entire premium paid. Hence, timing and market trend predictions play a vital role in the success of the option trading.
- Time decay: If the underlying stock or index we buy does not increase in price, the price of the option decreases as the expiration date approaches. This means that if your stock or index delays in rising, your profit will decrease, which is called time decay.
Call options are widely used for speculative trading, hedging against potential losses or leveraging small investments for potential profits.
Conclusion
Call options provide a powerful way to participate in market movements with limited risk exposure. Whether you are new to the stock market or looking to diversify your strategies, call options can enhance your profitability and provide a controlled approach to speculative trading. Using call options allows you to take advantage of market insights and manage risks effectively.
Disclaimers
This material is for educational purposes only and is not intended to be financial advice. Options trading involves risk and may not be suitable for all investors. Past performance is not a guarantee of future results. Consult a financial advisor before investing and ensure compliance with local laws. The Index Hedger is not liable for any financial losses.
Frequently Asked Question
What is a call option and how does it work?
A call option is a financial contract that gives the buyer the right, but not the obligation, to buy a specific stock at a predetermined price known as the strike price before the option’s expiration date. Call options allow investors to benefit from stock price growth without having full ownership of the stock.
When should I buy a call option?
Call options are typically purchased when investors are excited about a stock’s future and expect the price to rise. Buying a call option can be effective during a period of strong market growth or after positive company news.
What are the risks involved in buying a call option?
The main risk of buying a call option is losing the premium paid if the stock price does not reach the strike price by expiration. Other risks include time decay, where the option loses value as it gets closer to expiration, and high volatility, which can make prices unpredictable.
Can beginners use call options for trading?
Yes, but beginners must first understand the basics of options trading, including risks such as premium loss and time decay. Beginners are encouraged to use a demo account to practice before options trading or consult a financial advisor.
What are the benefits of buying a call option?
Call options provide traders with a powerful way to participate in market movements with limited risk of the premium paid (cost of the option) which limits the potential loss. By using options, the trader can secure his portfolio.
What is the difference between in the money and out of the money call options?
- An in-the-money (ITM) call option has a strike price lower than the current stock price, which gives it immediate intrinsic value.
- An out-of-the-money (OTM) call option has a strike price higher than the current stock price, which means it will only be profitable if the stock price rises above the strike price.
Can I sell my call option before expiration?
Traders can sell call options before expiration. This is called squaring off your position and occurs when the value of the option increases.