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What is a call option contract?
Call option is the contract in which, buyer has a right to buy shares of number at strike price before an expiry date.
In this, the buyer has no right for an obligation.
In this option, premium is paid for risk associated with an obligation.
These are purchased mainly for speculation and are sold for income purposes.
If the security price is more than the purchase price then, an option is profitable (buying the stock at a lower price than market value).
If the security price is lower than the purchase price, then the option is not profitable.
Types
The types of call option contract are as follows −
Long call option
In this before expiry date, market price (asset) will increase substantially beyond strike price. This is the most call option employed by investors in buying an option. To buy this option the buyer has to pay a premium amount to the broker.
In case of speculation, buyers will buy these options in anticipation of profits in future. If the price is below the current price then the buyer will lose premium amount and amount paid for agreement.
Short call option
An investor sells an option when the investor purchases assets at a predetermined price. Profits in this call are limited when shares are traded below strike price. This short call is suitable for assets which are expected to have moderate fall. This strategy generates upfront credit and may be effective in offsetting margin.
Advantages
The advantages of call option contract are as follows−
- Allows leverage for an investment.
- Number of option combinations is available.
- Potential risk is limited.
Disadvantages
The disadvantages of call option contract are as follows−
- The value decreases, if an expiry date is nearing.
- Pricing models are complex.
- Future behaviour is affected by strike price
Example
Assumes stocks of company P are at Rs.140/- per share and an investor (X) holds 500 shares in company P. in next month company share price may go beyond Rs.120/-. Now the investor assesses the call option at a premium of 50 paisa per contract.
Investors receives amount = (50/100)*500 ⇒ Rs.250/-
- If share goes more than Rs.140/- per share buyer will exercise his right and sell their shares.
- If share goes less than Rs.140/- per share buyer will hold his shares.
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