CALL BUYING STRATEGY

You can profit from an increase in a stock’s price by purchasing a call.

Buying calls is popular with options traders, beginners, and experts alike. This is a simple strategy: You buy calls on a stock or other equity whose market price you think will move higher than the strike price plus the premium by the end of expiration date or you buy a call whose premium you think will increase enough to outpace time decay. In either case, if your prediction is correct, you may be in a position to realize a positive return. If your view goes wrong, your option will lose the premium—generally much less than if you had purchased shares and they lost value.

TRADER OBJECTIVES

Buying call options may be appropriate for meeting several different purposes. For example, if you’d like to establish a price at which you’ll buy shares at some point in the future, you may buy call options on the stock without having to commit the full investment capital now. Or, you might use a buy low/sell high strategy, buying a call that you expect to rise and hoping to sell it after it increases in value. In that case, it’s key to pick a call that will react as you expect, since not all calls move significantly even when the underlying stock rises.

Some traders may purchase calls to hedge against short sales of stock they’ve made. Traders who sell short hope to profit from a decrease in the stock’s price. If the shares increase in value instead, they can face heavy losses. Buying calls allow short sellers to protect themselves against the unexpected increase and limit their potential risk.

CALLING FOR LEVERAGE

One major advantage of buying a call option is the possibility of leveraging your investment and realizing a much higher percentage return than if you made the equivalent stock transaction.

Say, for example, there are two traders. Trader A and Trader B.

Trader A

Trader A buys 100 shares of a stock at Rs.10 each, investing a total of Rs. 1,000.

100 shares x Rs. 10 per share = Rs. 1,000 Investment

In the next year, the stock rises in value to Rs. 15.

Trader A sells and makes Rs.500, or a 50% return on his initial investment.

100 shares x Rs. 15 per share = Rs. 1,500 Sale price

Rs.1,500 Sale price – Rs. 1,000 Investment

=Rs. 500 Profit or 50% return

Trader B

Trader B, however, invests the same Rs. 1,000 in options, buying 20 calls at a strike price of Rs. 12.50. Each call cost her Rs. 50, or 50 paise per share since her contract covers 100 shares.

Rs. 50 Per callx 20 Calls= Rs. 1,000 Investment

When the stock goes up to Rs. 15, her options are in the money by Rs. 2.50. Therefore, the value of her calls rises from 50 cents at purchase to at least Rs. 2.50 per share, a Rs. 200 gain per contract.

At expiration, the 20 contracts are now worth Rs. 5,000, or Rs. 4,000 above what she invested, a 400% return.

CALLS

Rs. 250 (Rs. 2.50 per share)

Rs. 250 per call x 20 Calls held = Rs. 5,000 Sale price

Rs. 5,000 Sale price – Rs. 1,000 Investment

= Rs. 4,000 Profit or 400% return

PERFECT TIMING

Buying calls can provide an advantage over several different time periods:

Short term.

Trader can profit if they sell an option for more than they paid for it, for example, if there is an increase in the stock’s price before the expiration.

Medium-term.

Over a matter of several months, traders can use call options to minimize the risk of owning stock in an uncertain market. Traders who want to lock in a purchase price for a year or longer can buy LEAPS, or periodically purchase new options.

Long term.

LEAPS (long-term equity participation securities) allow traders to purchase calls at a strike price they’re comfortable with and accumulate the capital to purchase those shares in the intervening time until expiration. But one of problems with LEAPS in India is that they are not liquid. Also LEAPS are only available in Index Options.

BETTER THAN MARGIN

For certain traders, buying calls is an attractive alternative to buying stock on margin. Calls buying offer the same leverage that you can get from buying on margin, but you take on less potential risk. If you buy stock on margin, you must maintain a certain reserve of cash in your margin account to cover the possible loss in value of those stocks. If the stock price does fall, you must add cash to meet the margin requirement, liquidate a portion of your position, or face having your brokerage firm liquidate your assets. If you purchase calls, you have the same benefit of low initial investment as the margin trader, but if the value of the stock drops, the main risk you face is loss of the premium, an amount that’s usually much smaller than the initial margin requirement.

CHOOSING A SECURITY

Most call contracts are sold before expiration, allowing their holders to realize a profit if there are gains in the premium. If you’ve purchased a call with the intent of owning the underlying instrument, however, you can exercise your right at any time before expiration, subject to the exercise cut-off policies of your brokerage firm. However, if you don’t resell and don’t exercise before expiration, you’ll face the loss of all of the premium you paid. If your call is out-of-the-money at expiration, you most likely won’t exercise. If your option is at the money, transaction fees may make it not worth exercising. But if your option is in the money, you should be careful not to let expiration pass without acting.

EXERCISING YOUR CALLS

In general, purchasing calls indicate a bullish sentiment, so you should consider a stock or stock index whose price you think is set to rise. This might be a stock you feel will rise in the short term, allowing you to profit from an increase in premium. You might also look for a stock with long-term growth potential that you’d like to own. Purchasing calls allows you to lock in an acceptable price, at the cost of the premium you pay.

PAY OF CHART

An Option payoff charts are profit and loss charts that show the risk/reward profile of an option or combination of options. As option probability can be complex to understand, P&L graphs give an instant view of the risk/reward for certain trading ideas you might have.

On December 3, 2021, Nifty is at 17,196.70. You buy a call option with a strike price of 17,300 at a premium of Rs. 262.35 with an expiry date of December 30, 2021. A Call option gives the buyer the right, but not the obligation to buy the underlying at the strike price. So in this example, you have the right to buy Nifty at 17,300. You may buy or you may not buy, there is no compulsion. If Nifty closes above 17,300 at expiry, you will exercise the option, else you will let it expire. What will be your maximum profits/ losses under different conditions at expiry, we will try to find out using pay-off charts.

If Nifty closes at 17,200, you will NOT exercise the right to buy the underlying (which you have got by buying the call option) as Nifty is available in the market at a price lower than your strike price. Why will you buy something at 17,300 when you can have the same thing at 17,300? So you will forego the right. In such a situation, your loss will be equal to the premium paid, which in this case is Rs. 262.35.

If Nifty were to close at 17,582.35, you will exercise the option and buy Nifty at 17,300 and make a profit by selling it at 17,582.35. In this transaction, you will make a profit of Rs. 262.35, but you have already paid this much money to the option seller right at the beginning when you bought the option. So 17,582.35 is the Break-Even Point (BEP) for this option contract. A general formula for calculating BEP for call options is the strike price plus premium (X + P).

If Nifty were to close at 17,600, you will exercise the option and buy Nifty at 17,300 and sell it in the market at 17,600, thereby making a profit of Rs. 300. But since you have already paid Rs. 262.35 as option premium, your actual profit would be 300 – 262.35 = 37.65.

For profits/losses for other values, a table is given below. This table is used to draw the pay off chart

Nifty at Expiry	Premium Paid	Buy Nifty at	Sell Nifty at	Pay off for Long Call Position
A	B	C		D=A+B+C
17100	-262.35	-17100	17100	-262.35
17150	-262.35	-17150	17150	-262.35
17200	-262.35	-17200	17200	-262.35
17250	-262.35	-17250	17250	-262.35
17300	-262.35	-17300	17300	-262.35
17350	-262.35	-17300	17350	-212.35
17400	-262.35	-17300	17400	-162.35
17450	-262.35	-17300	17450	-112.35
17500	-262.35	-17300	17500	-62.35
17550	-262.35	-17300	17550	-12.35
17600	-262.35	-17300	17600	37.65
17650	-262.35	-17300	17650	87.65
17700	-262.35	-17300	17700	137.65

The contract value for a Nifty option with a lot size of 50 and strike price of 17300 is 50 * 17200 = 8,56,000.

The maximum loss for such an option buyer would be equal to 262.35 * 50 = 13117.5.

As Nifty goes above 17,582.35 you start making a profit on exercising the option and if it stays below 17,582.35, you as a buyer always have the freedom not to exercise the option. But as seen from the table and chart you can reduce your losses as soon as nifty goes above 17,582.35. The long call position helps you to protect your loss to a maximum of Rs. 13117.5 with unlimited profit.