So, what exactly is a Call Option?
A call option is an options contract between two parties (buyer and seller) where the buyer of the contract gets the right but not the obligation to buy a specific quantity of the underlying asset in the future at a predetermined price (strike price) on or before a specific date (expiration date).
The seller of the call option faces the obligation to sell the underlying asset to the buyer of the call option in case the buyer chooses to exercise his right. Even if the call option seller is not holding the shares to be delivered at the time of entering the contract, he still has to buy shares from the spot market to be delivered in case the buyer calls for the delivery.
Price of the Call option has a direct relation with the price of the underlying asset. If the underlying asset moves up in price, then the price of the call option also goes up and vice versa. This is unlike put option which has an inverse correlation with the underlying. If the price of the underlying moves up, the price of the put option goes down and vice versa.
How is the moneyness of a Call option defined?
Moneyness defines each options contract, relating its strike price to the spot price of the underlying. The moneyness can be categorized into three different categories, namely.
- At the money (ATM) - ATM options are the option contracts having the strike price closest or equal to the spot price of the underlying asset. For e.g., If XYZ stock is trading at $50, then the closest strike price of the option to $50 will be referred to as ATM option.
- In the money (ITM) - ITM call options are those options whose strike price is lower than the ATM option. For e.g., If XYZ stock is trading at $50, then all options with a strike price lower than 50 are termed as ITM options.
- Out of the money option (OTM) – OTM call options are those options whose strike price is higher than the ATM option. In our, e.g. all call options having strike price above $50 are OTM call options.
Moneyness of Call option is exactly the opposite to that of the put option in the sense that all strike prices above the ATM option are OTM options in the case of a call and are ITM options in the case of a put option.
Similarly, all the strike prices below the ATM option are ITM options in the case of a call and OTM options in the case of a put.
Let us take some practical examples to understand the call option.
Let's assume person A is very bullish on XYZ stock which is currently trading at $100 and wants to bet on his assumption that the stock price will go up and that too within the expiration date. He buys an ATM call option of strike price $100 at a premium of $10, 30 days before expiration.
On the contrary, person B is not that bullish on XYZ and thinks it might not go above the current price of $100 within the next 30 days. So, he goes on and sells the ATM call option to B for $10.
Now at the expiration, one of the 3 cases would materialize.
Case 1 - XYZ closed above A$100
If XYZ closes below $100 at the expiration, say at $120 then clearly the assumption of the call option buyer stood right, and he would make a profit on his position. He would go on to exercise his right and buy XYZ at the predetermined price (strike price) of $100, whereas the current market price is being quoted $120.
His profit would be equal to the current price of the underlying – strike price – premium paid, i.e. $120 - $100 - $10 = $10.
As the profit of one party is the loss of another party in a contract, so whatever profit person A has made would be the loss of person B in the same contract, i.e. $10.
Case -2 - XYZ closed at A$100
If XYZ closes at $100 at the expiration, that means the predetermined price at which the buyer wanted to buy the underlying is exactly equal to the current market price. Therefore, there is no point in exercising the right of the buyer as both the current price and predetermined prices are same.
In this case, the buyer of the call option will lose the entire premium that he had paid to the seller at the time of entering the contract. The call option seller will keep the entire premium as his profit.
Case 3 - XYZ closed below A$100
If XYZ closes below $100, say at $80 at the expiration then clearly the buyer’s assumption has gone wrong, and he would not exercise his right to buy his underlying at $100 as he can get a better price of $80 directly from the spot market. In this case, also, the call option seller gets to pocket the entire premium of $10 as his profit which is equal to the loss of the buyer.
Remember, in all of the above cases, the potential profit of the call option buyers is unlimited as there is no limit to how high a stock can go. Higher the closing of the underlying above the strike price, higher would be the profit of the call option buyer. But the maximum loss would be equal to the premium paid even if the stock falls to a few cents.
The opposite holds true for the call option seller. Higher the closing of the underlying above the strike price, higher would be the loss of the call option seller. So pratically there is no limit to the maximum loss a seller can incur, but in any case, the profit would be limited to the premium received.