InvestorQ : What are the justifications for buying a call options?
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sarah Leo made post

What are the justifications for buying a call options?

Answer
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vidhya Laxmi answered.
2 years ago


When you buy a call option, you are basically purchasing a right to buy an asset at a future date at a fixed price. What are the circumstances under which a call option is purchased? Here are a few classic cases under which the call option can be bought.

· When you are bullish on a stock. This is the most common reason for buying a call option. When the stock price goes up, the intrinsic value of the call option also goes up and this results in the value of the call option also going up. Call option is a good way of playing a bullish market or bullish action in a stock with limited downside risk.

· Call option can also be bought when you expect the volatility of the stock to go up. This has nothing to do with the price. Even if the price of the stock moves little and the call volatility goes up sharply, then the call option can benefit substantially. Check out the table below.

Inputs

Inputs

Stock Price Now (Ps)

? 1,110

Stock Price Now (Ps)

? 1,115

Standard Dev - Annual (s)

20.00%

Standard Dev - Annual (s)

40.00%

Risk free Rate - Annual (R)

6.00%

Risk free Rate - Annual (R)

6.00%

Exercise Price (E)

? 1,100

Exercise Price (E)

? 1,100

Time To Maturity - Years (T)

0.0833

Time To Maturity - Years (T)

0.0833

Dividend yield (d)

1.00%

Dividend yield (d)

1.00%

Outputs

Outputs

d1

0.258

d1

0.211

d2

0.200

d2

0.096

N(d1)

0.602

N(d1)

0.584

N(d2)

0.579

N(d2)

0.538

Call Price (Vc)

? 33.31

Call Price (Vc)

? 61.21

-d1

-0.258

-d1

-0.211

-d2

-0.200

-d2

-0.096

N(-d1)

0.398

N(-d1)

0.416

N(-d2)

0.421

N(-d2)

0.462

Put Price (Pp)

? 18.75

Put Price (Pp)

? 41.65

In the above the stock price of Reliance has just moved up Rs.1110 to Rs.1115. Without a change in volatility, this would have resulted in the call value going up to just around Rs.36. At the same time, when the volatility is doubled from 20% to 40%, the call premium almost doubles to Rs.61.21. That is why playing on volatility via call options can be useful even if you are just playing on volatility.

· Call options can also be very useful as a hedge. If you are short on Futures and if the price of the futures goes up then you are exposed. To protect yourself, you can buy a higher strike call option and that will protect your downside risk.

Call options can also be used to create a spread in the market by buying a lower strike call and by selling a higher price call. This will ensure that the spread is captured and your cost of call options is reduced.