InvestorQ : I have decided to test the options market by purchasing call options on the Nifty and individual stocks. Are there are some strategies I can follow for buying calls?
Katherine Gonsalves made post

I have decided to test the options market by purchasing call options on the Nifty and individual stocks. Are there are some strategies I can follow for buying calls?

Arti Chavan answered.
2 years ago

Call options are the right to buying without the obligation to buy. A call options is an asymmetric contract where the buyer of the call has unlimited profit potential but limited loss. However, the seller of the option has unlimited loss potential and limited profit possibility. In effect, call options grant you the right to control stock at a fraction of the full price. This fraction is called the option premium and is the price of the right that you get.

Here are some of the key things you need to know about options:

· Like stocks, options are also financial securities

· In case of options, they derive their value from an underlying (stock or index)

· Broadly, there are 2 types of options viz. calls and puts

· Calls grant you the right but not the obligation to buy stock. If you are bullish about a stock, buying calls over buying the stock lets you control the same amount of shares with less money.

· In a call options, if the stock does rise, your percentage gains may be much higher than if you simply bought and sold the stock.

In reality it is not as simple as that. More often than not the buyer of the call option loses the premium and over a period of time these losses can be quite disconcerting for the buyer of the option. That is why understanding the basics of buying call options and fundamental valuation aspects are the key to buying options.

First understand the basics of call options

The buyer of call options has the right, but not the obligation, to buy an underlying security at a specified strike price. When you buy a Nifty 11,800 call at a price of Rs.25, you have the right to buy Nifty at 11,800. Obviously this right will be valuable only if the price of Nifty goes above 11,800; not otherwise. The Rs.25 paid for the option is a sunk cost. The reason you might choose to buy a call option, as opposed to simply buying a stock, is that options enable you to control the same amount of stock with less money. Essentially you need to invest less, although the lot sizes will be higher in most cases.

Unique features of a call option

Compared to buying stocks, buying call options requires a little more work. Knowing how options work is crucial to understanding whether buying calls is an appropriate strategy for you. There are several decisions that must be made before buying options. These include: Whether to buy the stock or the call; whether to buy the call or the put option, which strike to buy, how much premium to buy, which monthly contract to buy, how much premium to pay etc. You must also do a risk assessment based on the trade amount that can be supported. This is the maximum amount of money you would like to use to buy call options.

Options are a mechanism of leverage in the stock markets

That means you put a small margin and take a much larger position. For example, if there is a stock priced at Rs.700 and has a lot size of 1000 shares then the minimum lot size is Rs.7 lakhs. But if you buy a call option on the 720 strike call at Rs.7, then your total investment is jut Rs.7000 (7 x 1000). The good thing about buying options is that it does not leave you with too much of potential losses. In this case, the maximum loss is only Rs.7000 irrespective of which way the market moves and the stock gyrates. In short, options effectively allow you to control more shares at a fraction of the price. That is what leverage is all about in practice.

Merits and demerits of call options

In addition to being able to control the same amount of shares with less money, a benefit of buying a call option versus purchasing equity shares is that the maximum loss is lower. Plus, you know the maximum risk of the trade at the outset. For example, the maximum risk of buying Rs.50,000 worth of shares is theoretically the entire Rs.50,000, because, while it may be unlikely, the stock could theoretically become worthless as we have seen in the case of companies like Kingfisher, Deccan Chronicle etc. . In our example, the maximum risk of buying one call options contract (which grants you the right to control 1000 shares at Rs.2) is Rs.2000. The risk of buying the call options as opposed to simply buying the stock, is that you could lose the Rs.2000 you paid for the call options. That is all. If the stock fell in value and you were not able to exercise the call options to buy the stock, you would obviously not own the shares as you wanted to. Alternatively, if you simply bought the stock, you would own it right away, rather than having to wait on exercising the call options to potentially own the shares. Of course, in India most of the options are settled on a cash basis and not on delivery basis.

Another disadvantage of buying options is that they lose value over time because there is an expiration date. Stocks do not have an expiration date. Also, the owner of a stock receives dividends, whereas the owners of call options do not receive dividends. That is why options are called wasting assets and this is measured by Theta. Theta works in favour of the seller of the option and against the buyer of the option.

Before making any trade, it’s extremely helpful to know the maximum potential profit or loss you can incur. This is particularly true for options trades. The maximum potential profit for buying calls is the same profit potential as buying stock: it is theoretically unlimited. The reason is that a stock can rise indefinitely, and so, too, can the value of an option. On the other hand, the maximum potential loss is the premium paid to purchase the call options. If the underlying stock declines below the strike price at expiration, purchased call options expire worthless. If the stock does not rise above the strike price before the expiration date, your purchased options expire worthless and the trade is over.

How you make an options trade

Making an options trade can be slightly more complicated than a pure equity trade. You must first submit necessary documents and loss taking capacity before you are allowed to trade in futures and options in India. Once you have signed an options trading agreement, the process of buying options is similar to buying stock, with a few differences. You will typically begin by accessing your brokerage account and selecting a stock for which you want to trade options. Once you have selected a stock, you would go to the options chain. An options chain is where all options contracts are listed. After you’ve selected the specific options contract that you’d like to trade, an options trade ticket is opened and you would enter a buy to open order to buy call options. Then you would make the appropriate selections (type of option, order type, number of options, and expiration month) to place the order. With the knowledge of how to buy options, you can implement other options trading strategies. Buying call options is essential to a number of other more advanced strategies, such as spreads, straddles, and condors. Once you master buying calls, the world of options opens up in front of you. The choice is entirely yours how you want to make the best out of it.