Call Option

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What is a Call Option? Meaning.

A Call Option is an option that gives the buyer the right, but not the obligation, to purchase the underlying stock, commodity, or other financial instrument at a set time and strike price from the writer (seller) of the call option. Normally, one option contract for a stock confers the right to buy 100 shares of the underlying stock.

The writer must sell the commodity or financial instrument should the buyer so decide. The purchaser pays a premium (a fee) for this right.

The purchaser of a call option expects the price of the commodity/instrument to rise in the future; the writer expects that it will not, or he is willing to give up some of the upside (profit) from a price rise in return for the premium plus still having the opportunity to make a gain up to the strike price.

A Call Option is a Derivative

Call and Put Options are derivatives of (other) financial securities since their values are intrinsically linked to and depend on the price of some underlying asset. Other derivatives include swaps, forwards and mortgage backed securities.

Merits of options trading. Pros

1. Investors can use options for speculation reasons, for example wagering on predictive directions of a stock.
2. Options can be used to hedge financial risks like a decline in the market value of the underlying company or an overall stock market decrease/increase.
3. Options can help investors to buy a stock for less than its current market value or sell it for more than its current market value.
4. Investors can also benefit from a temporary "bear market" or dips in the price of the stock.
5. Options can be used to increase an individual's investment income through financial leverage

Disadvantages of options trading. Cons

1. Due to the speculative nature of options, this kind of investment decisions carries substantial risk of loss.
2. Options can be quite harmful if used incorrectly, one has to understand options before making such investment decision.

Example of a Call Option

An investor or a potential buyer (Holder) may want the right (the call option) to buy a residential or commercial property from a seller (Waiter) in the next two years at a designated strike value (intrinsic value) of $600,000. It could be that certain area developments will be performed. The investor (buyer) pays a fee of let's say $30,000 (usually a non refundable deposit) to lock the property in that right. This fee is called a "Premium".

During this period (that is in the stipulated contract time frame) during which the area developments are performed, the buyer will have the right to buy the property for the agreed $600,000 even if at that time the current market value of the property has increased a lot. His only "loss" will be the premium payment of $30,000. In the event that the contract has expired due to any reason and the buyer still wants to buy the property, he will have to pay the higher, actual market value. In that case, the seller will benefit from both the appreciated value and the Premium.

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Compare with: American-Style Option  |  European-Style Option  |  Put Option  |  Asian Option  |  Real Options  |  Futures Contract  |  Hedging  |  Warrant

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