Call & Put Option- How to Start Trading?

Overview

Generally, several different asset classes are typically included in investment portfolios, including stocks, MFs, exchange-traded funds (ETFs), bonds, etc.

However, new traders are typically drawn to futures and options since they believe they can produce significant profits in a short period by trading F&O with less investment, but there are equal risks associated with it. In the derivatives market, there are two primary categories of options accessible on the derivatives market- Call & Put options.

In contrast, to put options, which are used when you anticipate a decline in prices, call options are utilised when you anticipate an increase in prices. Investors could make money from price changes in stocks using either of these instruments. Thus, it becomes essential to have a basic understanding regarding the call & put option, how they work, what are the necessary points of difference, the key advantages, and the risks involved. Read further to find out more.

What Is a Call Option?

A call option contract grants the owner the option, but not the responsibility, to buy an agreed-upon quantity of the underlying security at an agreed-upon price within a certain amount of time, where the underlying security usually comprises a stock, bond, commodity, or other asset or instruments, etc.

Buyers must fork out a specific sum known as the option premium to purchase a call option. The buyers of the call option make profits when the value of the underlying security increases. When the call option holder exercises his option, the price at which he exercises such option is the strike price, and the time in which the sale may be made is referred to as the expiration or time to maturity.

If the call option holder fails the greatest, he may lose a call option the premium, which is the cost that the call option buyer must pay to purchase a call option. In contrast to the call option, a put option allows the holder to sell the underlying asset at a predetermined price on or before the expiration date. As a result, the call option gives the trader a chance to make huge profits while limiting losses to the amount of the premium paid. Accordingly, buyers have the option to pay a fixed price for a specific security, such as stock, as they come with expiry dates.

It is accurate to say that many organisations deal with unique and complicated options for various kinds of financial securities. On many other types of instruments, such as currencies, swaps, ETFs, etc., call options can be bought and sold. Investors who buy a call option are not required to buy and execute the underlying asset at the strike price.

How Do Call Options Work?

A call option contract is created on a securities exchange when an option seller or writer transacts with an option buyer. In this case, the option seller gives the buyer the option to buy a specific security at the agreed-upon price without any obligation attached to the same.

When it comes to equity call options, it is normal to have 100 shares included in each contract which means that the call option buyer contract can exercise the option to purchase 100 shares. Thankfully, the underlying stock at the designated strike price allows for the same action. On the other hand, the option premium is the cost that the investor who purchases a call option contract must pay. It is crucial to highlight that while options are conventional derivatives of the underlying assets, their market value is decided by the buyers and sellers in the market. When a call option expires, its intrinsic value decides whether the buyer will make money and the seller will lose it. It is the intrinsic value of a call option that decides whether the buyer will generate profits or lose the premium on the date of the expiry. Thus, there is a high likelihood that the call option will be worth money or have an inherent value. The option holder will be able to purchase the stock at a substantially reduced cost after exercising the option.

For example- Assume the price per share of Nippon India is Rs 100. G owns 100 shares with the primary intention of generating income in addition to the dividend. In the coming months, it is unlikely that stock prices will rise beyond Rs 160. When G analyses call options, he discovers a call trading of Rs 160, where each contract is worth 50p. In this case, the investor sells a single call option and receives Rs50 as a premium. The buyer option will become more advantageous if the share price is higher than Rs 160. Additionally, G must deliver the shares for Rs 160 per share. However, if the price stays below Rs 160, G will keep the shares without having any impact on a sale.

What Is a Put Option?

Like a call option, a put option is a contract that allows the option holder to either sell or short sell the underlying asset for the designated strike price up to a certain expiry date without any actual obligation to do the same. Strike price implies the value of the underlying security, which the put option holder holds the right to sell it. There could be several factors that affect the value of a put option, including the underlying asset’s price, such as the strike price, time decay, interest rates, market volatility, etc. It means that the value of the put option will rise.

The option strike price, time decay, interest rates, volatility, and so on. The value of the put option grows when the underlying asset’s price becomes increasingly volatile, as well as when interest rates are declining.

It is essential to keep in mind that as the expiry date of a put option approaches, the price of the underlying security asset becomes less unpredictable, or interest rates increase, and the value of the put option drops down. Therefore, traders who are convinced that the market value of the securities in question will decline over the ensuing days often buy put options.

Similarly, they sell put options when they expect the value of underlying assets is going to rise. Depending on the conditions, there are a plethora of ways to finish or close the option trade, but it is more likely that the call option will be exercised on the date of its expiry. However, if the option expires unprofitably and nothing happens, the price paid for options largely gets wasted.

How Do Put Options Work?

A put option has excellent prospects of going up in value. This indicates that a put option’s premium increases as the price of the underlying stock declines. On the other hand, the stock price increases significantly when the premium of a put option decreases.

When a put option is exercised, the investor gains a selling position in the stock. Consequently, a put option is frequently utilised to guard against the declines within a long stock position. Although put options can be utilised for speculation or hedging, the fundamentals are a little different. In essence, a put’s value intentionally rises when the value of the underlying stock declines and vice versa.

When you purchase a put option, you are speculating that the value of the underlying stock will drop. Additionally, you speculate on the value of the underlying stock when you sell a put option. For instance, H purchases one put option of Kissan company for Rs 100, where each option contract is for the same price. He holds the right to sell 100 shares of the Kissan company for Rs 100. This privilege, however, remains in effect until the expiration date. If H already has 100 shares, his broker will sell those shares at the strike price of Rs 100, thereby allowing any option writer to buy shares at a similar price to complete the deal.

What is the Difference Between Call Option & Put Option?

The call option and put option have some significant distinctions, including-

Types of the Call Options Strategies

Long Call Option– When purchasing call options, the most common stock call option strategy used by investors is a long call. It expects the market price of an underlying asset to rise significantly above the strike price before the expiration date.

To purchase a long call option, investors must pay a premium. When there is speculation of a rise in share prices, investors purchase these options in anticipation of higher earnings. However, if the price falls below the strike price, option holders will lose the premium paid for the option agreement.

For example, Suppose the price per share for the company ABC Ltd. is Rs 50. He purchases one call option of Rs 55 for ABC as the strike price, which will expire at the end of the month. If the price of ABC increases to Rs 60 in the following month, H can buy 100 shares at Rs 55 and sell them immediately at Rs 60, making a profit of Rs 5 for each share. But, if the price doesn’t increase above the strike price and it expires as stipulated, it will lead to a loss of Rs 500 on the premium.

Short Call Option- Selling a call option occurs when an investor writes a call option because he anticipates the underlying asset’s price to go down. A short-call strategy yields modest profit if shares are traded below the strike price but also carries significant risk if sold at a price greater than the strike price. A short-call options strategy is more relevant where the underlying asset is expected to experience a moderate fall. This method helps to generate upfront credit, which could be useful in margin offsetting. For instance, the share price of ABC stock is Rs 50. An investor, X, predicts that its price will plummet by the following month. X purchases one call option with a strike price of Rs 53 and an expiration date of one month. The seller will so earn a premium of Rs 2 per share, totalling Rs 200.

If ABC does not exceed Rs 53, this option will expire, and the option writer will profit Rs 200. The call option will be deemed to have been executed if the price rises to Rs 55 within a month. The writer of its option will have to sell his or her shares at Rs 53 rather than Rs 55, leading to a loss of Rs 2 per share for the option holder, which will result in a loss of Rs 200.

How to Calculate Call Option Payoffs?

The call option payoff in the call and put option NSE refers to the profit or loss realised by the option buyer or seller. Call option evaluation takes into account three unique factors: premium, strike price, and expiration date. Additionally, these variables are employed in the computation of call option payoffs.

Two different scenarios exist for call option payoffs-

Payouts for Call Option Buyers: Suppose you pay a premium of Rs 100 to buy a call option for a corporation. Here, the strike price of the call option is Rs 400, with its expiration date shall be Oct 20. Hence, if the stock price of the company reaches Rs 700, it is likely that you will make money on the investment made. The profit is deemed to have been made if the rise is greater than the predetermined amount. As a result, as the share price of the company rises, the reward value becomes unlimited.

The following formulas, the payoff and profit amount are determined as-

Payoff = Spot Price – Strike Price

Profit = Payoff – Premium Paid

Payment to Call Option Sellers: Please be conscious that the seller’s call option payoff computation is not significantly distinct from the buyer’s call option calculation. When the price drops, you can profit if you sell a specific options contract with a comparable expiration date and striking price. Furthermore, depending on the nature of your call option, your losses could be limited or unlimited.

Whenever you are obliged to buy the underlying stock at spot pricing, your losses are also probably unlimited. However, in this situation, your single income is only permitted to be the premium that is gathered following the expiration of the option contract.

The following formulas are used to determine the payouts and profit for sellers-

Payoff = Spot Price – Strike Price

Profit = Payoff + Premium Paid

How to Calculate Put Option Payoffs?

It’s crucial to note that the generating of profit or carrying of losses depends on two independent factors: first, look at the anticipated reward of exercising the option; second, consider the preliminary payment paid for buying the option. It is important to remember that the first component is the same as the spread between the strike price and the price of the underlying security. Your financial benefit during the expiration time rises when the underlying price drops below the strike price. Your financial benefit during the expiration time rises when the underlying price falls below the strike price.

Payoffs for Put Option Buyers: With a put option, the buyer has the opportunity to sell the underlying asset for the indicated strike price. In reality, the spot price of the underlying determines entirely whether the buyer of the option makes a profit or loses money.

Nevertheless, the buyer may benefit significantly if the current price falls below the strike price at expiration. In essence, the buyer gains more money the lower the spot price goes. However, if the underlying spot price exceeds the strike price, the buyer lets his option expire.

Typically, the buyer will carry out this action while not exercising his option. In this instance, the premium paid to acquire the put option represents the buyer’s loss.

The Payoff for Put Option Sellers: The put option seller assesses a premium fee while selling the put option. Furthermore, the put option buyer’s gain or loss is based on the underlying current market price.

Therefore, whatever profit the buyer makes usually results in a loss for the seller. Additionally, the put option on the seller will be exercised if the spot price is lower than the strike price at expiration. If the situation is reversed, the buyer leaves his option unexecuted while the seller retains the premium money.

When Should You Buy a Call Option?

Investing in a call option may result in a profit if the value of the underlying security rises before the option’s exercise date. Whenever the value of security rises, it should be purchased at the strike price and quickly sold at a higher market price. The call option holders may also have to wait slightly longer to discover if the price will rise further.

The price of the shares must rise above the striking price for the option to be exercised. The investor would simply experience a loss of premium in such a scenario even if the price of securities falls to zero. Profit or intrinsic value accruing to investors when executing a call option is the remaining securities proceeds after deducting the striking price, call option premium, and any associated transactional expenses.

Given that the former gives the holder more leverage, buying a call option may be more profitable than buying a security. As opposed to just selling the security, in the event of a price increase, a holder stands to win significantly. Irrespective of how much the securities prices fall, it is likely for investors to lose some amount, but any additional losses that an investor otherwise sustains would be limited. It results in a larger return for a cheaper investment. With an increase in the price of the securities, the investor may also sell options as it allows the investor to earn without having to pay for securities.

When Should You Sell Call Option?

Selling call options may be an alternative for the investor if he predicts a drop in the value of the call options in the future. The premium money, nevertheless, may still be regained if the asset value falls below the strike price. Generally, there are two ways to sell call options- naked call options and covered call options.

Naked Call Option

When the ownership of the relevant asset is not present, the holder, in this instance, sells the option. It carries a large amount of risk because if a buyer decides to exercise an option, the seller must purchase the asset at market price to match the order. Sellers of call options face considerable risk because there is no price cap on an asset, which may result in a significant loss. As a result, a seller will typically charge a fee that may balance the risk involved. Naked call options are typically exercised by large firms that can successfully diversify their risks.

Covered Call Option

In this case, an option is protected by an underlying asset. The seller already owns his or her asset, and by selling this option, he or she earns a risk-free profit from the premium charged for a call option. The seller, on the other hand, does not benefit if the price of an asset rises dramatically. In this situation, the option holder is prohibited from selling for higher prices but only at a strike price.

Advantages of Call & Put Options 

• Leverage – The primary advantage of trading options is leverage. Rather than making payment for the entire transaction, the call & put option has a lower capital requirement which requires traders to undertake high-value positions with capital restricted to a premium.
• Excellent Hedging Tools- Although options are great hedging tools, they must be employed with prudence. Traders may mitigate the likelihood of their equity falling in value by using options. For instance, a trader can purchase a put option to reduce the possibility of a price decline if they hold stock in a firm and are concerned about it.
• Higher Potential to Gain Short-Term Returns-Stocks offer a lower likelihood for quick profits as compared to call-and-put options. But the trader must use the right strategies. The profit percentage is larger in options since traders expend less money on them while still making returns that are practically comparable to those from stocks.
• Risk Aspects – Compared to futures or cash markets, options are comparatively safer. The premium paid represents the risk of loss associated with option purchases. On the other hand, buying the underlying asset might involve lower risk with buying or selling options.
• Options Strategies – These offer the chance to earn from both price rises and falls, which is another advantage of options trading. In such cases, traders cannot be fully certain which way prices will move but still anticipate a major change. In line with their speculations, traders could develop a strategy that generates profits regardless of the underlying asset’s price direction by combining various options.
• Cost-Effective in Nature– Options are contracts for underlying assets and are less expensive than stocks due to the premium representing a small portion of the transaction value. It means that the option holders could generate remarkable profits through the use of the remaining funds. For instance, it would cost Rs 10,000 for a trader to buy 100 shares of a company for Rs 100 apiece. However, in the case of options, they could purchase one contract of 100 shares for merely Rs 500.

Disadvantages of Call & Put Options

• Complex in nature- Trading options include three decisions: direction, time, and price, which makes it potentially quite complicated. Before putting an option strategy into practice, traders must take into account all three facto.
• Requirement of Demat A/c- to trade shares in India, one must open a demat account and trading account. Although options trading can be done with the same demat account, there is a further requirement that requires the call, and options traders must sign the options trading agreement that discloses the risks related to options trading, as required by SEBI.
• Uncertain Gains- Gains are uncertain because all options strategies are based on predictions and assumptions about the future. Only when the share prices move in the direction that the trader anticipated will the trader make money, and unfortunately, if it doesn’t happen, then traders will face losses.
• Trading costs and commissions- When compared to equities, trading fees and commissions are significant in the case of call & put options. The costs increase with the complexity of the strategy and the number of calls and puts.
• Tax Payments – Since all gains from trading options are short-term, they are all subject to the 15% short-term capital gains tax. Consequently, the concerned trader loses a portion of his profits towards payment of taxes.

Conclusion

As a result, the call-and-put options are opposites. When the underlying security’s price is anticipated to rise in the future, buying a call option entitles you the right to purchase it at a fixed price at expiration. A put option is purchased when the asset price is predicted to fall, and it grants the right to sell the underlying stock at a certain price on expiration.

When a trade goes successfully, traders who speculate on the security’s price might earn lucrative rewards. It is appropriate for those with a high-risk tolerance and a thorough understanding of futures and options. Although these fundamentals might make the concepts easier to understand, understanding the market is an entirely distinct procedure that requires knowledge, discipline, and patience, which comes from extensive training. So, before investing in the market, make sure you balance all of the profits and hazards.

FAQs

1. What is the best way to sell put options?

You can use an options trading platform or your brokerage to open an options account to sell put options. After that, you’ll be able to place a sell order for put options, specifying the strike price, expiration date, and underlying stock.

2. Why do the volatility of call and put options differ?

When your estimates are different, you may need to undertake further investigation to determine the cause of the imbalance. However, interest and dividends are the most obvious reasons for the call and put options having differing IVs. Please keep in mind that interest rate assumptions can vary between expirations, equities, and strikes.

3. Which is the more secure option, a call or a put?

Neither of the call or put options is particularly superior to the other. However, the security would depend on the investment goal and the risk tolerance ability of the investor. But, the majority of the risk is ultimately determined by changes in the market price of the underlying asset.

4. When should you purchase a call option?

Calls are typically purchased to increase leverage when investors are bullish on a stock or other security. Call options aid in limiting the greatest loss that an investment may experience, as opposed to stocks, where the full value of the investment may be lost if the stock price falls to zero.

5. When should an investor consider selling a call option?

It would be wise to think about buying a call option rather than the underlying stock outright if you think the market value of the stock will increase. However, it is a smart idea to sell or write a call option if there are reasons to assume that the underlying stock’s market price will fall further, trade sideways, or remain steady.

6. What do weekly and monthly options mean?

Standard monthly call options are frequently traded options that expire on the last Thursday of the month. Further, SEBI & the exchanges recently introduced weekly options that are specific to Bank Nifty with the primary objective of reducing option risk by requiring them to expire weekly. These weekly options have recently piqued the interest of traders.