Covered Call Strategies Explained
Introduction to Options
What Are Options?
An option is a contract that gives its owner a choice. Specifically, it offers the right, but not the obligation, to buy or sell an asset at a set price by a certain date. Think of it like putting a refundable deposit on a house. You pay a small fee to lock in the purchase price for a period of time. If you decide to buy, you exercise your right. If you change your mind, you just lose the deposit, not the full house price.
Think of options as an agreement, a contract giving you the right, but not the obligation, to buy or sell an underlying asset – typically shares listed on the NSE or BSE – at a predetermined price (called the strike price) on or before a specific date (the expiration date).
Every options contract has two sides: a buyer and a seller. The buyer pays for the right to make a choice, while the seller receives that payment and is obligated to fulfill the contract if the buyer decides to exercise it. The seller is also known as the writer of the option.
The Parts of an Option
Every option contract is defined by a few key terms. Understanding these is crucial to understanding how options work.
Strike Price
noun
The predetermined price at which the underlying asset can be bought or sold.
The strike price is the price that matters. It's the price at which the deal is set. If the market price moves favorably compared to the strike price, the option becomes more valuable.
Expiration Date
noun
The date on which the option contract becomes void.
An option doesn't last forever. The expiration date is the deadline. The owner must decide whether to exercise their option on or before this date. After it passes, the contract is worthless.
Premium
noun
The price of the option contract itself, paid by the buyer to the seller.
The premium is the cost to purchase the option. It's what the buyer pays the seller for the privilege of having that choice. This payment is non-refundable, regardless of whether the buyer exercises the option.
Calls and Puts
There are two fundamental types of options, each corresponding to a different expectation about the market's direction.
A call option gives the holder the right to buy an asset at the strike price.
You buy a call option when you believe the price of the underlying asset will go up. For example, if a stock is trading at $45, you might buy a call option with a $50 strike price. If the stock's price rises to $60, your option to buy it at $50 becomes valuable. The seller of the call is obligated to sell you the stock at $50 if you choose to exercise it.
A put option gives the holder the right to sell an asset at the strike price.
You buy a put option when you believe the price of the asset will go down. Let's say a stock is trading at $45. You might buy a put option with a $40 strike price. If the stock's price falls to $30, your right to sell it at the higher price of $40 is valuable. The seller of the put is obligated to buy the stock from you at $40 if you exercise your option.
| Option Type | Buyer's Right | Buyer's Goal | Seller's Obligation |
|---|---|---|---|
| Call | To buy the asset | Price goes up | To sell the asset |
| Put | To sell the asset | Price goes down | To buy the asset |
Now that you understand the basic building blocks, you have a solid foundation for exploring how these contracts are used in different trading strategies.