Buy call option A Beginner’s Guide to Call Buying

Acquiring Call Options

Previously, we examined the foundation for call options and understood their general application. In this chapter, we shall further explore call option dynamics and become well-versed in both acquiring and writing them. Here’s a summary:

If you anticipate that the underlying asset will appreciate in value, purchasing a call option represents a sensible approach

If the price doesn’t increase, or even declines, then the call option purchaser will face losses

The call option buyer would incur a cost equivalent to the premium (agreement fees) they remitted to the seller/writer

Considering these three points will provide us with a superior understanding of call options.

Understanding Call Options Through a Case Study

This analysis suggests that purchasing a call option could make commercial sense. The illustration demonstrates why investing in a call option might prove beneficial.

Let’s assume Tata Motors’ equity has declined to its 52-week low, and I believe it might be opportune to consider investing. I have several thoughts about this potential trade which I shall share with you.

Tata Motors is a quality fundamental equity, there is no disputing this

I believe the substantial decline in the equity price could be an overreaction by the market to volatility in Tata Motors’ business cycle

I anticipate that the downward trend in the equity price will soon cease and eventually reverse

However, I am hesitant to purchase the equity for long-term holding presently due to concerns about further declines

Additionally, I am reluctant to buy Tata Motors’ futures because I worry about potential mark-to-market losses

Nevertheless, I don’t want to miss out on the opportunity of a sharp reversal in the equity price

Overall, my sentiment towards Tata Motors’ equity price is positive in the long run. However, a possibility of short-term losses exists if the share price continues to remain weak, albeit the likelihood of this occurrence is relatively low. This places me in a dilemma regarding the appropriate course of action to take.

Regarding my predicament, a call option on Tata Motors represents an obvious choice, due to reasons I shall discuss shortly. Here’s a glimpse at the company’s option chain:

We can observe that the equity trades at Rs 465 (highlighted in blue). I have invested in the 475 call option with a premium of Rs 12.50 (shown by red box and arrow). You may be questioning why I’ve selected this strike price out of the multitude available (highlighted in green).

Strike price selection is a complex subject, and we shall examine it later, but for now, let us simply accept that 475 represents the appropriate one to purchase.

Determining the Intrinsic Value of a Call Option (Upon Expiry)

The call option will conclude with one of three possibilities in the forthcoming 15 days: familiarity with these scenarios is likely.

Scenario 1 – The equity price surpasses the strike price, reaching 505

Scenario 2 – The equity price falls below the strike price, reaching 450

Scenario 3 – The equity price remains at 475

The three scenarios we discussed are comparable to those in Chapter 1; thus, it is assumed that you comprehend the P&L computation with the specific value of the spot indicated.

Here’s an idea that requires exploration:

It is evident that when the expiry date for Tata Motors approaches, three distinct possibilities exist for the price movement: an increase, a decrease, or unchanged

Considering the scenario where the price is 505, which exceeds the strike at 475, what about other strikes in between, such as 485, 495, and 500? Is it possible to make any generalisations about the potential profit and loss outcomes?

In scenario 2, the price is given as 450, and this falls below the strike of 475. How do other strike prices, 460, 465, and 470, impact the P&L? Is there a generalisation that can be made?

I would like to refer to the possible prices of the spot (at the time of expiration) as the “Possible values of the spot upon expiration” in order to gain a superior understanding of the profit and loss (P&L) for a call option.

To start, let’s explore the intrinsic value of the option at expiration. The intrinsic value of a call option upon expiry represents the non-negative amount that the holder can expect to receive if they choose to exercise it. In simpler terms, if you own a call option that has become profitable, what amount of money are you entitled to receive when it reaches its expiration? This can be expressed mathematically as:

IV = Spot Price – Strike Price

The intrinsic value of the 475 Call option will be calculated if Tata Motors is trading at 505 on expiry in the spot market.

= 505 – 475

= 30

If Tata Motors is trading at 450 on the expiration date, here’s the intrinsic value of the option:

= 450 – 475

= -25

Keep in mind, both a call or a put option’s intrinsic value must be non-negative; so we shall maintain it at 450.

= 0

We aim to consider the intrinsic worth of this option, calculate how much I shall gain dependent on Tata Motors’ expiry value and make some general conclusions about a call option purchaser’s profit and loss.

For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding call option mechanics proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, call options offer sophisticated mechanisms for capitalising on anticipated price movements.

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