Options Trading Basics

Call Option Basics

A call option is a financial contract that gives the buyer the right, but not the obligation, to buy an asset at a predetermined price (called the strike price) before the option expires. For AlgoTest users, call options are useful tools for speculating on price increases or hedging against potential losses.

Real-Life Example of a Call Option

Imagine you’re interested in buying a plot of land worth ₹5,00,000 today, but you’re unsure if it will increase in value. You pay the owner ₹1,00,000 upfront, giving you the right to purchase the land in six months for ₹5,00,000. If the land price rises to ₹10,00,000, you exercise your right and buy it at ₹5,00,000, making a substantial profit. If the price drops or stays the same, you simply walk away, losing only the ₹1,00,000 you paid for the option.

This setup mirrors how call options work in the stock market, where the buyer has the right to purchase shares at a fixed price before the contract expires.

Example in Stock Market

Suppose a stock is trading at ₹70. You pay ₹5 as a premium for a call option with a strike price of ₹75, expiring in one month. There are three possible scenarios at expiry:

1. Stock rises to ₹85: You exercise the option, buy the stock at ₹75, and profit ₹5 per share after accounting for the premium.
2. Stock falls to ₹65: You don’t exercise the option and lose only the ₹5 premium.
3. Stock remains at ₹75: You break even on the option, losing just the premium.

Benefits of Call Options

1. Leverage: Call options allow you to control a large amount of stock with relatively low capital. This amplifies potential profits while limiting the downside to the premium paid.
2. Limited Risk: Unlike buying stocks outright, where losses can be substantial, the maximum loss in a call option is the premium paid upfront.
3. Profit from Upward Movements: Call options are ideal when you anticipate that a stock’s price will rise but want to limit your downside risk.

Payoff Structure

The payoff for a call option is directly related to the stock price at expiry. If the stock price exceeds the strike price, the buyer profits, while if it stays below, the buyer only loses the premium. Here’s a basic visualization:

Stock Price	Action	Profit/Loss
₹85	Exercise option	+₹5/share
₹75	No action, break even	-₹5 (premium)
₹65	No action	-₹5 (premium)

Conclusion

Call options provide flexibility for traders looking to capitalise on price increases while limiting risk. AlgoTest users can create and test various call option strategies using the Strategy Builder and Simulator, ensuring they make informed