Call Option

Updated on April 9, 2024
Article bySusmita Pathak
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Call Option?

A call option is a financial contract that permits but does not obligate a buyer to purchase an underlying asset at a predetermined (strike) price within a specific period (expiration). It occurs when an investor predicts that the price of a stock, bond, or commodity will rise in the future to profit.

Call Option

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From entering this derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more, the buyer pays a premium until exercising it. If the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more price rises, the buyer makes a profit. But if the price falls, the contract expires worthless, and the seller collects the premium. Investors chose this option to improve income, reduce risk, plan investments, and manage taxes.

Key Takeaways

  • Call option meaning describes a financial contract that allows but does not compel a buyer to buy an underlying asset at a predefined price within a certain time frame. However, if the buyer exercises the option, the seller must sell the asset.
  • The buyer benefits from a price increase (speculation) or subsequently hedging to reduce positioning risks. The seller earns money from the contract’s premiums.
  • It normally necessitates the purchase of 100 shares at once. The buyer pays a premium from when they enter this derivative contract until they exercise it.
  • It is the inverse of a put option, which allows the seller to sell the underlying asset at a predetermined price on or before the expiration date.

Call Options Explained

Call option trading lets the buyer purchase an asset at a discounted price if handled carefully. In other words, they can buy the desired asset at a predetermined price for a specific period, but it is not an obligation in any manner. It is the polar opposite of a put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more, where the seller can sell the underlying asset at a predetermined price on or before the expiration date.

When trading stocks, bonds, commodities, or any other financial instrument, the goal is to profit from a price increase (speculation) or reduce positioning risks (hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more) later. The buyer hopes the upward movement of prices does not impact their buying decision through this option.

Call Option Benefits

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Buyers and sellers enter into call option contractsOption ContractsAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more via a brokerage firm, which is a middleman. It usually requires trading 100 shares at once. It can be long (buying) or short (selling). The strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more for the asset is what the seller comes up with for a specific period. If a buyer agrees on that price and date, the broker connects them with the seller. Both parties remain anonymous, and the broker does everything is necessary to fulfill the arrangement. The buyer must pay a premium to demonstrate their commitment to the contract.

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Call Options vs Put Options Explained in Video

How Call Option Works?

In the call option, the seller sets the strike price, but it is up to the buyer to agree or disagree.

Let us say a seller sets a strike price of $5 per share or $500 for 100 shares in a call option. On the other hand, the buyer speculates that prices would eventually rise to $10 and agrees to the contract expiring in March 2022.

Even if the price rises to $8 until March 2022, the buyer will still honor the deal and make a profit. On the other hand, the buyer can choose not to exercise the contract if the current market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more falls below $5 per share and will lose the premium.

Features

Trader's Rights In A Call Option

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Types of Call Options

As mentioned below, there are two sorts of call options:

#1 Long

In this case, the buyer has the right, but not the obligation, to purchase an asset at a future strike price. A key advantage of this option is that it enables a buyer to plan ahead and buy the asset at a lower price. A lot of traders place such a call on stocks with high dividend yield as share prices usually surge as the ex-date or ex-dividend date nears. After that, on that date, the price decreases. One must note that the long call holders receive the dividend only when they choose to exercise the option prior to that specific ex-date.

Let us look at the following graph to understand the concept of long call options better.

#2 Short

In the case of short call options, the seller promises the buyer to sell shares at a set strike price in the future. As the name suggests, these are the exact opposite of long call options. Generally, option sellers utilize them for covered calls. Alternatively, they may utilize these for call options where they already have ownership of the underlying asset for their options.

Let us look at the following short call option graph to better understand the concept.

Real-World Example

Let us look at the following behavioral call option exampleCall Option ExampleCall 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.read more to understand how it works:

Jim is interested in purchasing Google stock, trading at $130 per share. He speculates that prices would rise to $140. But Jim does not have enough money to acquire the shares. So, he enters into a three-month contract to purchase 100 shares for $13,000.

Jim realizes that his predictions were incorrect before the expiration date but waits until maturity. The Google stock price rises to $134 per share on the expiration date. Jim continues to buy Google stock, gaining $4 per share, for a total profit of $400 on one call option.

Buying A Call Option

The buyer decides to buy a call option after ensuring that a company’s stock value will rise in the future. It, thus, is never a loss for them. Next, investors (holders) enter into the contract to be settled on a future date at a fixed strike price, anticipating a price rise in the future. Finally, the brokerage firm matches them with the seller with similar preferences for further processing.

If the underlying asset price rises above the strike price at expiration, the buyer can purchase the asset at a reduced price as agreed upon in the contract. Conversely, if prices fall, the buyer has the opportunity to cancel the contract as it is not legally enforceable or obligated. Therefore, it is a win-win ‘bullish’ deal for buyers.

Selling A Call Option

Here, the seller, also referred to as a call option writer, seeks to profit by selling assets at the maximum possible price, i.e., as much below the strike price as possible. They want the asset price to fall or keep their shares safe until they get the best price, even after entering the contract. In other words, they want buyers to cancel the contract and buy on the open market if prices remain low until the expiration date.

When the buyer discovers that the asset’s market value is less than the predetermined price, they cancel the purchase. Meanwhile, the seller profits handsomely from the premiums that interested buyers paid for the assets. If on the expiration date, the market price of the asset is higher than the strike price, the buyer purchases it at the set price.

Even while the seller earns a substantial sum for 100 shares, they miss out on a better deal if the stock value would have risen. Additionally, they have no premium amount to collect from the contract. And above everything else, they lose all their shares. As a result, it is a ‘bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more‘ situation for sellers.

Types of Sell Call Options

There are two ways to sell call options:

  1. Covered: Here, the seller genuinely owns the underlying asset and is protected from a loss if the buyer exercises their option and purchases it.
  2. Naked: Here, the seller, who does not own the underlying asset, can sell it, but in doing so, they are not protected against potential losses.

Frequently Asked Question (FAQs)

How does the call option work?

A call option is a contract that allows but does not compel buyers to acquire an asset at a predetermined price within a certain time frame. Buyers and sellers enter into these contracts through a brokerage firm. When trading stocks, bonds, commodities, or any other financial instrument, the seller sets the strike price for this option, but it is up to the buyer to agree or disagree with it. The buyer makes money if the price of the underlying asset rises. If the price drops, the contract becomes worthless.

What is the difference between a call option and put option?

The put option allows sellers to sell assets, and the call option allows buyers to acquire assets. When the market value of financial instruments rises, the latter allows buyers to benefit by purchasing assets at a discounted rate. On the other hand, the former allows sellers to sell underlying assets at a fixed price at a later date, even if the stock, bond, commodity, or other asset’s current market value is lower.

How to sell call option?

Call options can be sold in two ways:
#1 – Covered: In this case, the seller truly owns the underlying asset and is protected from loss if the buyer chooses to buy it.
#2 – Naked: In this case, the seller can sell the underlying asset even if they do not own it, but they are not covered against potential losses.

This has been a guide to call option and meaning. Here we explain how does call option works along with features, examples, and types. You may also learn more about financing from the following articles –

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