What is a Call Option?
A call option is a type of options contract that grants the buyer the right, but not the obligation, to purchase a specified amount of an underlying asset at a predetermined price (known as the strike price) within a certain period. Call options are typically used for speculation on the future price of an underlying asset, such as stocks, or for hedging purposes. Sellers of call options, known as “writers,” receive a premium from buyers for undertaking the obligation to sell the asset at the strike price if the buyer decides to exercise the option.
Key Features of a Call Option:
- Premium: The price paid by the buyer to the seller for the option contract.
- Strike Price: The fixed price at which the holder can buy the underlying asset.
- Expiration Date: The date by which the option must be exercised.
- Underlying Asset: The financial asset (e.g., stock, commodity) that the option contract is based on.
Examples of Call Options
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Speculative Trade: Suppose Company XYZ’s stock is currently trading at $50. An investor believes the stock price will rise and buys a call option with a strike price of $55, expiring in 3 months. If the stock price rises above $55 before expiration, the investor can exercise the option, buy the stock at $55, and potentially sell it at the market price for a profit.
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Hedging: A business that uses oil as a raw material may buy call options on oil to hedge against a potential rise in oil prices. If oil prices increase significantly, the call option allows the business to purchase oil at the lower strike price, offsetting the increased costs in the oil market.
Frequently Asked Questions (FAQs)
What happens if a call option is not exercised?
If a call option is not exercised by the expiration date, it expires worthless, and the buyer loses the premium paid to purchase the option.
Can call options be sold before expiration?
Yes, call options can be sold before expiration. The holder can sell the option contract to another investor in the options market, potentially realizing a profit if the option’s value has appreciated.
What is the difference between a call option and a put option?
A call option gives the holder the right to buy the underlying asset, whereas a put option gives the holder the right to sell the underlying asset at a predetermined price within a specific timeframe.
What factors affect the price of a call option?
The price of a call option is influenced by several factors, including the underlying asset’s current price, the strike price relative to the current price, the time remaining until expiration, volatility of the underlying asset, interest rates, and dividends paid by the underlying asset.
How do you calculate the intrinsic value of a call option?
The intrinsic value of a call option is the difference between the underlying asset’s current market price and the strike price, provided the market price is above the strike price. If the market price is below the strike price, the intrinsic value is zero.
Related Terms
Put Option
A put option is an options contract that gives the holder the right, but not the obligation, to sell a specified amount of an underlying asset at a predetermined price within a specific period.
Strike Price
The strike price is the set price at which the holder of an options contract can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.
Premium
The premium is the cost paid by the buyer to the seller for an options contract.
Expiration Date
The expiration date is the final date by which the option must be exercised or it becomes void.
Underlying Asset
The underlying asset is the financial instrument on which an options or futures contract is based, such as stocks, bonds, commodities, or indices.
Online References
- Investopedia: Call Option
- Cboe Global Markets: Options Education
- The Options Industry Council: Call Options
Suggested Books for Further Studies
- “Options as a Strategic Investment” by Lawrence G. McMillan
- “Options, Futures, and Other Derivatives” by John C. Hull
- “Trading Options Greeks: How Time, Volatility, and Other Pricing Factors Drive Profits” by Dan Passarelli
- “The Bible of Options Strategies: The Definitive Guide for Practical Trading Strategies” by Guy Cohen
Accounting Basics: “Call Option” Fundamentals Quiz
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