Call Options Definition & Examples
Call Options are derivative contracts that enable the buyer of the option to exercise his right to buying particular security at a pre-specified price popularly known as strike price on the date of the expiry of such a derivative contract. It is important to note that the call option is a right, not an obligation. The following call option examples provide an outline of the most common call option examples and their utility in the normal course of business as well as for speculation.
Examples of Call Options
Let us understand examples of the call option.
Call Option Example #1
Alex, a full-time trader lives in Chicago and is bullish on the S&P 500 index which is currently trading at 2973.01 levels on 2nd July 2019. He believes that the S&P 500 index will surpass the levels of 3000 by the end of July 2019 and decided to purchase a call option with a strike price of 3000. Details of the same are mentioned below:
S&P 500 Index closed at 3020 levels on the date of expiry. In such a case the profit made by Alex provided he held the option till expiry date is equivalent to $8 (after adjusting for the $12 paid by him)
Points gained at expiry = 3020 – 3000 = 20 points
On the contrary, if the S&P Index expired below 3000 levels on the expiry date, the call option will be worthless and loss to Alex will be equivalent to the premium paid by him for acquiring the call option.
Call Option Example #2
SIRI is an Investment Management firm and specializes in managing a portfolio of a basket of securities on behalf of its clients spread across the globe. The firm is holding stock of Facebook in its portfolio at an average cost of $150. The firm believes that facebook stock will continue to remain in the range of $140 to $160 during March 2019 and decided to sell call option of strike price $170 at an average cost of $3. At the end of the March month, the stock ended at $168. Since the stock price is below the strike price the option ended worthless for the call option buyers and SIRI was able to pocket the $3 premium per lot by selling the call options. This is one of the reasons behind the selling of call options.
Call Option Example #3
Buying Call Options is an excellent way to take leverage positions with low investment. Through the below example lets understand the same:
Greg is bullish on the stock of HDFC Bank and expects the company to deliver excellent results for the quarter ended March 2019. The stock of HDFC Bank is trading at $200 and Greg is having $10000 to invest in the same. Greg expects the stock of HDFC Bank to reach $250 by the end of the month. He has two options:
Option 1: Buy 50 shares of HDFC Bank in cash and thereby invest the $10000.
Option 2: Buy one call option with a strike price of $200 which is available for $20 having a lot size 500 shares.
In both of the above cases, his total investment will be $10000 only.
Now let’s assume the stock reached the level of $250 at the end of the month.
Thus we can see call options, being leveraged trades magnify the returns if the stock moves in the direction of the option buyer.
Call Option Example #4
Call Options along with put options can be combined for Hedging as well with limited Risk. Let’s understand this utility with the help of another example:
Ryan an investor feels that the price of RELIANCE currently valued at $55 by the market will move significantly in the next three months either upside or downside. He intends to make money through this move but without actually buying the stock and also by taking less risk.
Ryan created a straddle by buying a call and put off a strike price of $55 expiring in three months. The call of $55CE cost him $9 and the PUT of $55PE cost him $6 with lot size 500 shares.
Thus his total cost is as follows:
Now by entering into this strategy, Ryan profit/loss potential on expiry will be as follows:
Call Option Example #5
Call Options are also used by institutions to enhance portfolio returns by writing (selling) call options. Let’s look at an example to understand this:
The share of TCS is trading at $120 on 1st March 2019. Max Mutual Fund is holding 100000 shares of TCS and doesn’t expect the price of TCS share to move very much over the next few months. Max Mutual Funds decided to wrote (sell) call options against the shareholding.
Let’s assume that the March $130 calls are trading at $8 and Max Mutual Fund sells 100 lots (1000 shares each). As an option writer max mutual fund receives a premium of $800 and takes on the obligation to deliver 100000 shares at $130 each if the buyer exercises the contracts on expiry.
Now let’s assume in March the share price hasn’t moved and the option expires worthless. The value of the underlying portfolio of shares is unchanged, but by writing call option max mutual fund has made $800 which will increase the overall portfolio return for the max mutual fund. Thus call options help in magnifying returns.
Conclusion
There are innumerable situations where call options can be used by investors to increase their return or to minimize their risk.
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