InvestorQ : What exactly do we mean by Call Options?
Bhavik Nehru made post

What exactly do we mean by Call Options?

Bhavik Nehru answered.
3 years ago
A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date in case of American option. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Let us understand this point with an illustration with the call option on Reliance Industries. An investor buys One European call option on Reliance Industries Ltd. at the strike price of Rs. 1250 at a premium of Rs. 25. If the market price of Reliance Industries on the day of expiry is more than Rs. 1250, the option will be exercised. The investor will earn profits once the share price crosses Rs. 1275 (Strike Price + Premium i.e. 1250 + 25). Suppose stock price is Rs. 1300, the option will be exercised and the investor will buy 1 share of Stock "A" from the seller of the option at Rs 1250 and sell it in the market at Rs.1300 making a profit of Rs. 25 {(Spot price - Strike price) - Premium}. However, this is only for understanding. In reality, such options are cash settled. That means; on the settlement date, the difference of Rs.25 will be automatically credited to the trading account of the buyer of the call option. You can also boo profits during the month and reverse the transaction when the option price goes up. Let us look at an alternate scenario when the stock price of RIL goes down. In another scenario, if at the time of expiry stock price falls below Rs. 1250 say suppose it touches Rs. 1200, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs.25) paid which shall be the profit earned by the seller of the call option. The beauty of buying the call option is that the loss of the buyer of the call option remains capped at Rs.25 even if the stock price goes down to Rs.900. You basically limit your downside risk with the option.