Question

a) Explain the benefit and limitation of buying a call option.

Answer 1

Hedging and Trading using the call options is a best way of making returns from the investments if the conditions at the time of buying or selling  them are favourable.

We can use Call options to “call” on the market on the basis of an underlying asset such as shares of company at a predetermined price with a predetermined mejurity date. Due to this reason, call options often increase in value when the underlying asset increases.

So the question is "what are the benefits and limitations of buying a call options?"

The benefits of Call Options

1. Leverage benefit – options allows us to leverage our investment. It is taking advantages of an underlying asset for the cost of purchasing an asset itself. If we held the option till the expiry date, it will be in the money and we will receive the same benefit as if we were purchased the stock options.

2.Advantages of Flexibility – There are alot of option combinations for us. Since there are varios option exercise prices and mejurity dates, We can write option positions or can buy them. If the conditions are favourable, we can make a ‘no risk’ trading.

3. Potential Risk are limited – The maximum amount we may lose when we purchase a call option contract is the amount we have invested and not more than that.

The limitations of Call Options

1.Decay of Time – As far as the buyers of the options are concerned, the exponential rate for value of an option decays during the last 30 days of its life is the biggest issue. Due to this reason, it will be better to concentrate on the selling of an option contract, due to which time decay then works in your favour. I

We may sell a short dated option at a higher exercise price in combination with calls, Due to which the overall cost of the long dated option price fall and also give us a good profit if there is an increase in price.

2. Pricing Models may be Complex – Normally call option pricing may involves various components, such as intrinsic value, time value, probability, volatility, etc. There is relationship between the option price and price movements in an underlying asset. When we buy a call option having a high volatility and the price moves up as per our expectation there may not be increase in option prices accordingly.

3. may be In, At or Out Of the Money – The exercise price will get affected by the future behaviour of our call option. Out-of-the-money options are normally at lower cost and if the underlying asset volatile on the price, we may make a killing.If it went the oposit possition, the value of option decrease very quickly.