A call option also referred to as simply call is a financial transaction between two parties, a buyer and seller for this type of option trading. In this contract, the buyer has a right but no obligation to buy an agreed quantity of any commodity or financial instrument from the seller of the option at a definite time (the expiration date) for a certain price- called as the strike price.
The seller (or “writer”) is obligated to sell the commodity or financial instrument if the buyer decides so. The buyer pays a fee (called a premium) for this right.
The buyer in call option buys the underlying security hoping that price will rise in the future. The seller hopes that price do not rise in the immediate future or is prepared to give up some of the profit in lieu of premium (which is paid immediately) thereby giving an opportunity to make profit up to the strike price.
Call options are highly profitable for the buyer when the underlying contract moves up, making the price either closer to, or above, the strike price. The call buyer considers that the price of the underlying asset will move up by the exercise date. The risk is restricted to the premium. The profit for the buyer can be v be very high, and is limited by how high the underlying instrument’s spot price climbs up. When the price of the underlying security exceeds the strike price, the option is said to be “in the money”.
The call writer does not anticipate the price of the underlying instrument to rise. The writer sells the call to collect the premium and does not obtain any gain if the stock surpasses the strike price.
The initial transaction in this situation (buying/selling a call option) does not involve supplying of a physical or financial asset (the underlying instrument). In fact it is the granting of the right to buy the underlying instrument, in lieu for a fee — the option price or premium.
Exact specifications may vary depending on option style. A European call option lets the holder to use the option (i.e., to buy) only on the option expiration date. An American call option lets the holder to use the option at any time during the life of the option.
Call options can be bought on numerous financial instruments other than stock in a corporation. Options can be bought on futures on interest rates, and on commodities like gold or crude oil. A tradable call option is different from Incentive stock options or a warrant. An incentive stock option, the option to buy stock in a certain company, is a right established by a corporation to a certain person (mainly executives) to buy treasury stock. When an incentive stock option is used, new shares are issued. Incentive stock options are not exchanged in the open market. In the opposite case, when a call option is exercised, the underlying security is transferred from one owner to another.
An investor normally ‘buys a call’ when he anticipates the price of the underlying security will go over the call’s ‘strike price,’ optimistically by a long way so, before the call expires. The investor pays a non-refundable premium for the legal right to exercise the call at the strike price, meaning he can buy the underlying instrument at the strike price. In general, if the price of the underlying instrument has gone over the strike price, the buyer pays the strike price to actually purchase the underlying asset, and then sells the same security and pockets the profit. Of course, the investor can also hold onto the underlying asset, if he reckons it will continue to climb even higher.
Call Option Example on a stock
An investor normally ‘writes a call’ when he anticipates the price of the underlying instrument to stay under the call’s strike price. The writer (seller) obtains the premium up front as his or her profit. However, if the call buyer makes up his mind to exercise his option to buy, then the writer has the obligation to sell the underlying instrument at the strike price.
In most cases the writer of the call does not essentially own the underlying instrument, and must buy it on the open market so as to be able to sell it to the buyer of the call. The seller of the call will lose the difference between his or her buy price of the underlying instrument and the strike price. This risk can be enormous if the underlying asset leaps abruptly in price.
- The current price of XYZ Corp stock is $45 a share and investor ‘Pete’ anticipates it will go up a lot. So, Pete purchases a call contract for 100 shares of XYZ Corp from ‘Mark,’ who is the call writer/seller. The strike price for the option deal is $50 per share, and Pete pays a premium up front of $5 per share, or $500 total. If XYZ Corp’s stocks does not perform well enough, and Pete does not exercise the contract, then Pete has lost $500.
- ABC Corp stock in the course of time climbs up to $60 per share before the contract is expired. Pete exercises the call option by purchasing 100 shares of XYZ from Mark for a total of $5,000. Pete in turn sells the stock on the market at market price for a total of $6,000. Pete has paid a $500 contract premium in addition to a stock cost of $5,500. Thus, Pete received $6,000, yielding a net profit of $500.
- If, on the other hand, the XYZ stock price falls to $40 per share by the time the contract expires, Pete will not use the option (i.e., Pete will not buy a stock at $50 per share from Mark when he can purchase it on the open market at $40 per share). Pete will lose his premium, a total of $500. Mark, though, keeps the premium with no other out-of-pocket expenses, yielding a profit of $500.
- In this deal, the break-even stock price for Pete is $55 per share, i.e., the $50 per share for the call option price plus the share premium of $5 per share, paid for the option. If the stock climbs $55 per share when the option expires, Pete can make up for his investment by exercising the option and buying 100 shares of XYZ Corp stock from Mark at $50 per share, and then right away selling those shares at the market price of $55. His entire costs are then the $5 per share premium for the call option, in addition to $50 per share to buy the shares from Mark, for a total of $5,500. His overall earnings are $55 per share sold, or $5,500 for 100 shares, yielding him a net $0. This transaction does not take into account broker fees or other transaction costs.
Prices of Option
Option values differ in the value of the underlying security over time. The price of the call contract should reflect the “probability” or chance of the call finishing in-the-money. The call contract price in general will be higher when the contract has long duration to expire (except in cases when a high amount of dividend is present) and when the underlying financial security demonstrates more volatility. Accurately reaching this value is one of the key functions of financial mathematics. The most widely used method is the Black–Scholes formula. No matter what the formula used, the buyer and seller must agree on the initial value (the premium or price of the call contract), or else the exchange (buy/sell) of the call will never materialize. Correction in Call Option: When a call option is in-the-money i.e. when the buyer is earning profit, he has several options. Few of them are as follows:
- He can sell the call and book his profit
- If he still expects that there is chance of making more money he can carry on to hold the position.
- If he is interested in maintaining the position but at the same time would like to have some protection, he can purchase a defensive “put” of the strike that suits him.
- He can sell a call of higher strike price and change the position into “call spread” and thus limiting his loss if the market reverses.
In the same vein, if the buyer is bearing loss on his position i.e. the call is out-of-the-money, he can make several adjustments to minimize his loss or even make some profit.