Call and Put Option

Call and put options allow traders to take positions based on expected price movements without immediately buying or selling the underlying asset. A call buyer expects the price to rise, while a put buyer expects it to fall.

• A call option buyer expects the asset’s price to rise, while a put option buyer expects it to fall.
• A call option gives the buyer the right to buy an asset at the strike price before or on expiry.
• A put option gives the buyer the right to sell an asset at the strike price before or on expiry.
• The premium is the amount the buyer pays to enter the option contract.
• The buyer’s maximum loss is usually limited to the premium paid.
• The seller’s risk can be considerably higher because the contract must be fulfilled if the buyer exercises the option.
• For a call buyer, the break-even price is the strike price plus the premium.
• For a put buyer, the break-even price is the strike price minus the premium.
• Options are traded in exchange-specified lots rather than as individual units.

A call option is a contract that gives its buyer the right, but not the obligation, to buy a specified quantity of an underlying asset at a predetermined strike price. This right remains valid until the contract expires.

The call option buyer pays an upfront amount called the option premium. The seller, also known as the option writer, receives this premium and must honour the contract if the buyer exercises it.

Suppose an investor buys a call option with a strike price of ₹120. If the market price rises above ₹120, the option may develop intrinsic value. However, the investor must also account for the premium when calculating the actual profit.

For example, if the premium is ₹5 per share, the buyer’s break-even price is ₹125. A market price above ₹120 does not automatically mean that the overall position is profitable.

If the market price remains below the strike price at expiry, the buyer can allow the option to expire. The buyer’s loss is then limited to the premium paid.

Call options are standardised contracts traded on recognised stock exchanges like BSE (Bombay Stock Exchange) or NSE (National Stock Exchange). Their strike prices, expiry dates, and lot sizes are determined according to the contract specifications set by the exchange.

To enter into the contract, the call buyer pays a premium to the call seller. In return, the buyer receives the right to buy the underlying asset at the strike price.

The outcome depends mainly on the relationship between the market price and the strike price:

• Market price above the strike price: The call is in the money and has intrinsic value.
• Market price equal to the strike price: The call is at the money.
• Market price below the strike price: The call is out of the money and has no intrinsic value.

The premium can still change before expiry even when the option has no intrinsic value. Time remaining, expected volatility, interest rates and changes in the underlying asset’s price can all influence the premium.

A call buyer may close the position by selling the option before expiry. The buyer does not necessarily need to hold the contract until it expires.

Suppose an investor expects a company’s share price to rise from its current level. The investor buys a call option with the following details:

• Strike price: ₹2,300
• Premium paid: ₹50 per share
• Break-even price: ₹2,350 per share

Scenario 1: The share price rises

Assume the market price reaches ₹2,400 at expiry. The option has an intrinsic value of ₹100 per share because the market price is ₹100 above the strike price.

After subtracting the premium of ₹50, the buyer earns a net profit of ₹50 per share.

Pay-off calculation: ₹2,400 − ₹2,300 − ₹50 = ₹50 per share

Scenario 2: The share price remains below ₹2,300

If the market price remains below the strike price, exercising the call would not be beneficial. The buyer can allow it to expire.

The maximum loss is the premium of ₹50 per share.

The securities quoted are for example purposes only and not a recommendation.

A put option gives its buyer the right, but not the obligation, to sell an underlying asset at a predetermined strike price before or on expiry. The put seller must buy the asset at that price if the buyer exercises the contract.

Put buyers generally expect the underlying asset’s price to decline. They may also buy puts to reduce the effect of a price fall on shares already held in their portfolio.

Suppose an investor owns shares currently trading at ₹100 and buys a put with a strike price of ₹100. If the market price falls to ₹90, the option gives the investor the right to sell at ₹100, subject to the contract’s settlement rules.

If the market price remains above ₹100, the investor can allow the put to expire. In that situation, the loss on the option is limited to the premium paid.

Additional Read: What is Futures and Options

A put option can be used for speculation, risk management or income generation. The outcome differs depending on whether the trader buys or sells the contract.

• Buying a put option: The buyer expects the market price to fall below the strike price. The option generally becomes more valuable as the underlying asset declines.
• Selling a put option: The seller expects the price to remain at or above the strike price. The seller keeps the premium if the option expires without being exercised.
• Using a put as a hedge: An investor holding shares may buy a put to limit the effect of a possible decline.
• Closing the position early: A put buyer or seller can generally exit the position before expiry by taking an opposite position in the same contract.

A put seller takes on the obligation to buy the underlying asset at the strike price if the contract is exercised. This can result in a considerable loss when the market price falls significantly below the strike price.

Put premiums generally rise when the underlying asset’s price declines, although other factors also affect their value. These include time to expiry, expected volatility and changes in market conditions.

Suppose an investor buys a put option with the following contract details:

• Current market price: ₹800
• Strike price: ₹600
• Premium paid: ₹20 per share
• Break-even price: ₹580 per share

If the market price falls to ₹500 at expiry, the option has an intrinsic value of ₹100 per share.

After subtracting the ₹20 premium, the buyer’s net profit is ₹80 per share.

Pay-off calculation: ₹600 − ₹500 − ₹20 = ₹80 per share

If the market price remains at ₹600 or above, the buyer may allow the option to expire. The maximum loss is then limited to the premium of ₹20 per share.

Additional read:What is Trading 

Traders can choose from several strike prices for the same underlying asset and expiry date. These options are classified as in the money, at the money, or out of the money.

Suppose NIFTY is trading at ₹20,000. The classifications may be understood as follows:

In-the-money options have intrinsic value. At-the-money options have a strike price close to the current market price, while out-of-the-money options have no intrinsic value.

The premium, probability of profit, and sensitivity to market movements differ across these categories. A lower premium does not necessarily mean lower risk, especially when the probability of the option expiring worthless is higher.

Call and put options provide opposite contractual rights. A call concerns the right to buy, while a put concerns the right to sell.

The risk profile changes when an option is sold. A call seller may face theoretically unlimited losses, while a put seller may face a substantial loss if the underlying asset falls sharply.

Understanding the basic terms associated with call and put options is crucial for investors to navigate the options market effectively.

1. Spot price: The spot price refers to the current market price of the underlying asset. For options, this is the price of the asset within the stock market at the time of consideration.
2. Strike price: The strike price, also known as the exercise price, is the price at which the buyer and seller agree to buy or sell the underlying asset upon exercising the option. It is the fixed price specified in the option contract.
3. Option premium: The option premium is the amount paid by the buyer to the seller for the option contract. It is essentially the price of the option. The premium is paid upfront by the option buyer and is non-refundable, regardless of whether the option is exercised or expires worthless.
4. Option expiry: Options contracts have a finite lifespan, known as the expiration date or expiry. The expiry date is the date by which the option contract must be exercised or allowed to expire. In many markets, including India, options contracts typically expire on the last Thursday of the month.
5. Settlement: Settlement refers to the process by which option contracts are resolved.

Understanding these payoffs helps traders assess risk, reward, and strategy effectiveness when dealing with options contracts.

(S = spot price at expiry, K = strike price)

Option buyers and sellers have different risk and reward profiles. Buyers pay a premium for a right, while sellers receive a premium in exchange for accepting an obligation.

Option buying limits the loss to the premium, but the entire premium can be lost if the contract expires worthless. Option selling provides limited income through the premium but may expose the seller to considerably higher losses.

While buying a call option in the share market, numerous things can happen, resulting in profits or losses for the buyers. If you are a call option buyer, here are the things that can happen to your call options on expiry:

• Out-of-money call options: This is when the market price is lower than the strike price of a call option. In this case, you lose money and incur losses.
• In-the-money call options: This is when the market price is higher than the strike price of a call option. In this case, you earn and make profits.
• At-the-money call options: This is when the market price is equal to the strike price of a call option. In this case, you break even; you do not make profits or incur losses.

A call seller receives the premium upfront but takes on the obligation associated with the contract.

• Out-of-the-money call: The market price is below the strike price. The option generally expires without intrinsic value, and the seller retains the premium.
• In-the-money call: The market price is above the strike price. The seller may incur a loss if the intrinsic value exceeds the premium received.
• At-the-money call: The market price is close to the strike price. The seller generally retains the premium, subject to applicable settlement and transaction charges.

A short call can carry theoretically unlimited risk because there is no fixed upper limit on how far the underlying asset’s price can rise.

A put buyer benefits when the underlying asset falls sufficiently below the strike price.

• Out-of-the-money put: The market price is above the strike price. The option has no intrinsic value, and the buyer generally loses the premium.
• In-the-money put: The market price is below the strike price. The option has intrinsic value, but the price must fall below the break-even level for the position to earn a net profit.
• At-the-money put: The market price is close to the strike price. The buyer generally loses the premium.

A put option may also be used as protection for shares already held. In that case, gains in the put may partly offset losses in the underlying investment.

In call option put option, if you are the seller of a put option, here are the things that can happen at expiry:

• Out-of-money put options: This is when the market price is higher than the strike price of a put option. In this case, you make profits.
• In-the-money put options: This is when the market price is lower than the strike price of a put option. In this case, you incur losses.
• At-the-money put options: This is when the market price is equal to the strike price of a put option. In this case, you make a profit equal to the premium amount.

Call and put options can be used to express a market view, manage risk, or protect an existing position. A call buyer generally expects the underlying asset to rise, while a put buyer generally expects it to fall.

The buyer’s loss is usually limited to the premium paid. However, option sellers may face significantly higher losses because they must fulfil the contract when it is exercised.

Profitability depends on more than whether an option is in the money. Traders must consider the strike price, premium, break-even level, time to expiry, volatility, lot size, settlement rules and applicable charges. Options are complex derivative instruments, so their payoff structure and risks should be understood before trading.