What is a Call Option?

In the derivatives market, you may want to buy shares or sell them at a specific price in the future. On this basis, there are two types of options available in the derivatives markets – Call options and Put options. Call options are those contracts that give the buyer the right, but not the obligation to buy the underlying shares or index in the futures. They are exactly opposite of Put options, which give you the right to sell in the future.

Let us understand this with an example:

Suppose the Nifty is quoting around 16000 points today. If you are bullish about the market and foresee this index reaching the 16100 mark within the next one month, you may buy a one month Nifty Call option at 16100.

Let's say that this call is available at a premium of Rs 30 per share. Since the current contract or lot size of the Nifty is 50 units, you will have to pay a total premium of Rs 3000 to purchase two lots of call option on the index.

If the index remains below 16100 points for the whole of the next month until the contract expires, you would certainly not want to exercise your option and purchase at 16100 levels. And you have no obligation to purchase it either. You could simply ignore the contract. All you have lost, then, is your premium of Rs 3000.

If, on the other hand, the index does cross 16100 points as you expected, you have the right to buy at 16100 levels. Naturally, you would want to exercise your call option. That said, remember that you will start making profits only once the Nifty crosses 16130 levels, since you must add the cost incurred due to payment of the premium to the cost of the index. This is called your breakeven point – a point where you make no profits and no losses.

When the index is anywhere between 16100 and 16130 points, you merely begin to recover your premium cost. So, it makes sense to exercise your option at these levels only if you do not expect the index to rise further, or the contract reaches its expiry date at these levels.

Now, let's look at how the writer (Seller) of this call option is fairing.

As long as the index does not cross 16100 , he benefits from the option premium he received from you. Index is between 16100 and 16130, he is losing some of the premium that you have paid him. Once the index is above 16130, his losses are equal in proportion to your gains and both depend upon how much the index rises.

In a nutshell, the option writer has taken on the risk of a rise in the index for a sum of Rs. 30 per share. Further, while your losses are limited to the premium that you pay and your profit potential is unlimited, the writer's profits are limited to the premium and his losses could be unlimited.