How Call option works in derivative market
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In the derivative market two types of options are available, the call options and the put options. Call options are contracts which enable you to buy at a specific price in future. Similarly put options are those contracts which enable you to sell at a fixed price in the future. First we can discuss about how call option work in derivative market.
In call option, you can buy a certain amount of shares or an index, at a predetermined price, on or before the expiry date. This predetermined price is also known as the strike price or exercise price. Expiry date is the date before which you can handle your position. For availing this facility, you have to pay a minimum amount to the seller/writer of the option in the exchange. This is necessary for minimizing loss of a seller/writer. This is essential because the writer of the call option may loss if the market price is rise beyond the strike price before the expiry. And the seller is forced to sell you shares at strike price even if it is loss. The premium payable amount is also driven by the market.
Following are the main features of call option.
- Specifics: For buying a call option you must place a buy order with your broker specifying the predetermined price and the expiry date. Also specify the amount that you are ready to pay.
- Fixed Price: Is also known as strike price or exercise price, the fixed amount at which you agree to buy the assets in the future.
- Option Premium: It is the premium amount you must paid first to the exchange, which then passes to the option seller.
- Margins: You can sell call option by an initial amount not with the entire sum. Also you have to maintain a minimum amount in your trading account or with your broker to meet the exchange requirement.
If you expect that the price of an index will rise in the near future then you can select that index to purchase. Some of them include CNX Nifty 50, CNX IT and Bank Nifty on the NSE and 30 other shares on the BSE. Let us analyse Index call option with an example. Consider you buy nifty at 6100 call option when nifty is at 6000. If nifty remains below 6100, you must ignore option, and you are in a loss of 1000. 30 rupees for each thus total 100 units you need to pay 3000 premium amount. Even if Nifty goes above 6100 you will not get any profit due to the premium cost. Your profit increases only if Index climbs above 6130. Next is stock call option. On some certain stocks those satisfy stringent criteria SEBI has permitted options trading. These certain stocks are actually selected from top 500 stocks. It was selected based on these factors such as average daily traded value and average daily market capitalization in the previous six months. Let us understand how it works by taking reliance Industries. It is assumed that share price will go upwards, based on an important announcement made at AGM. When the spot price of Reliance is Rs.950, you may be able to buy a call option of Reliance at a strike price of 970. Since call option was quoting Rs. 10, you end up paying a premium of Rs. 6000(Rs 10*600 units). And you will get profit once the price of Reliance crosses 980 per share (i.e., strike price 970 + premium paid of Rs 10).
In stock market time is of great importance. To achieve maximum profit, buy at a low price and sell at high price. You are expecting a possible rise in price of an asset. A call option will help you to fix the buying price. And you can protect yourself by paying a small premium amount and can avoid losses in future. Buy call option when future price rise and sell call option when future price fall.
The initial payment/margin required for buying or selling call option
You need to pay a small amount as premium to the seller if you buy an option. And seller has to pay margin money to create his/her position. Margin money is often calculated as a percentage of the total value. A buyer safe his position by paid premium amount however the seller has only limited gain and his potential loss is unlimited. In order to limit the huge loss due to adverse movement of the market it is better for a seller to deposit a margin amount as security with the exchange. Deposit a large amount if the market volatility is higher.
How you can settle down your call option
Once you buy or sell call option it is necessary to exit or settle your call option. In two ways you can exit, either before the expiry date through an offsetting trade, or you can stay in your position until the option expires. Let us look first how a buyer can square off his position. If you want to square off your position before expiry you need to sell the same number of call option that you have purchased earlier. That is, if you have purchased two stock’s call option of lot size 500 and strike price of Rs 100, and if it expires at the end of April, you must have to sell the two stocks before expiry in order to square off your position. In this business your profit or loss amount is the difference between the premium at which you bought option and at which you sold them out. To nullify call option someone also choose to buy put option of same underlying asset and expiry date. The disadvantage of this type squaring off is you will have to pay some premium amount to the put option writer. Out of these selling your call option is better because you will get at least the premium amount from the buyer. For a call option sellers in order to square off their position you have to buy the same number of call option that you sold out. That is one with identical strike price and maturity date.
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