So, by now you know that a call option is a right to buy a stock or the index without the obligation. In return for that right without obligation, the buyer of the call option pays a premium to the seller of the call option. But do you know how exactly a call option works? Here is a quick guide to how a call option actually works in the stock markets…
I have opened my equity trading account; am I ready to buy options?
You need to open a separate F&O account to trade futures and options. Your equity trading account can be used to buy equity shares and ETFs. You need an F&O account to buy call options with documentation requirements also being more than a pure equity trading account.
That means once I buy the call option, it comes into my demat account?
No, your demat account is only for equities, ETFs etc. Call options are contracts and they will be held in your F&O trading account not in your demat account. Call options do not give you ownership.
But the call option is a right to buy an asset like RIL, SBI etc; am I right?
Yes a call option is a right to buy an asset but in India all options are cash settled. There is actually no delivery against call options. The profit if any will be credited to your F&O trading account.
What if my call option is running into a huge loss?
When you buy a call option, your loss is limited to the premium paid. If you bought SBI 250 call at Rs.4 then your maximum loss is Rs.4 even if SBI goes down to Rs.200. Of course, if you have sold call options then y our losses can be unlimited if the stock price moves up sharply.
So once I buy a call option, can I exercise the call option if the price goes up?
The question of daily exercise of options arises only in case of American options. In India, all index and stock options are in the nature of European Options. That means they can only be exercised on the day of expiry which is the last Thursday of the month.
Does that mean I am stuck in my call options position for the full month?
Not at all! You can sell your call option in the F&O market just like you sell shares. Let us explain! If you bought Tata Steel 650 call option at Rs.10 and if the stock price moved up from Rs.640 to 660 in 2 days, the call option value will also go up to say Rs.18. So you can sell the call option in the market and book profit of Rs.8 (18-10). You need to check for liquidity of options.
Why do option prices fall rapidly when the expiry approaches?
That is called time decay of options. Remember, options prices have two components viz. intrinsic value and time value. If you buy a Tata Steel 650 call option at Rs.20, when the CMP is Rs.658, then Rs.8 (658-650) represents the intrinsic value and the balance Rs.12 represents the time value. It is the time value that decays because when there is no time left there is no time value left.
That means it is quite easy to make money by buying call options since risk is limited…
It is interesting to note that over 90% of all options are known to expire worthless. So, options are actually weighted in favour of the seller. That means you have to be very careful that you can better your breakeven point of the option.
What exactly is this breakeven point of the call option?
It is the level you start making profit. For example, if you bought a Reliance 920 call option at a price of Rs.10 then your breakeven price is Rs.930 (920+10). You also need to factor in the brokerage cost, stamp duty; STT and GST on top of this and that will give the real breakeven level for the option.
On the expiry day can I leave the call option to expiry or should I square it up?
You can do either but remember there is a huge difference in terms of the cost of STT. If you square off the option then the STT will be charged at just 0.05% of the premium value. If you exercise the call option or even if you leave it to expiry and if it is an ITM option then it will be treated as equity and STT will be imposed at 0.125% of the actual value. The difference will be huge. It is always better to square off your options on the expiry day rather than leaving it to expiry.
I have heard of rollover in futures. Can we also roll over options?
When we talk of rollover in futures, we essentially close the current month position and take fresh position in the next month. You can do the same thing in the case of call options also. The only difference is that in case of options the exchange does not provide a roll window.
Should I buy ITM options, ATM options or OTM options?
There are no hard and fast rules. But buying very deep OTM options does not make sense as they normally expire worthless. Buying deep ITM options is almost like buying futures. When you are bullish on a stock, you can either buy a call option that is near ITM or near OTM. The farther you go from the stock price, the lower are your chances of making money on call options.
Finally, do I need to show profits on call options in my tax returns?
Of course, that is money earned by you and it has to be shown. Profits or losses incurred on call options and put options are normally shown under the head of business income.