A Call Option is a financial derivative contract that provides its holder with the right, but not the obligation, to buy a specified quantity of an underlying asset at a predetermined price, known as the "strike price" or "exercise price," within a specified period, typically until a predetermined expiration date. Call options are widely used in financial markets for various purposes, including speculation, hedging, and generating income.
Key Features of Call Options
Underlying Asset: Call options are typically associated with various underlying assets, including stocks, commodities, indices, currencies, and bonds and other assets. The choice of underlying asset depends on the specific market and the available options.
Strike Price: The strike price is the price at which the holder of the call option has the right to buy the underlying asset. It is specified in the option contract and remains constant throughout the option's life.
Expiration Date: Call options have a fixed expiration date, beyond which the option is no longer valid. The holder must exercise the option (if desired) before or on this date.
Premium: To acquire a call option, the buyer pays a premium to the option seller (also known as the writer). The premium represents the cost of the option and compensates the seller for taking on the obligation.
Exercise vs. Expiry: Call options can be exercised (utilized) by the holder at any time before or on the expiration date. If the option is not exercised by the expiration date, it expires worthless.
Profit Potential: Call options offer the potential for profit if the price of the underlying asset rises above the strike price. The higher the asset's price relative to the strike price, the more profitable the option becomes.
Limited Risk: The risk for the holder of a call option is limited to the premium paid. This limited risk is in contrast to short selling, where potential losses can be unlimited.
How Call Options Work
Consider the following example to illustrate how a call option works:
- Underlying Asset: Stock XYZ
- Current Stock Price: $100
- Call Option Details: Call option on XYZ with a strike price of $110, expiring in one month.
- Option Premium: $5
In this scenario, the call option holder has the right to buy shares of stock XYZ at $110 per share until the option's expiration date, which is one month away. If the stock's price rises above $110 during this period, the call option can be profitable. Here are possible outcomes:
If the stock price remains below $110, the option holder may choose not to exercise the option, resulting in a loss equal to the premium paid ($5).
If the stock price rises to $115, the option holder can buy the stock at $110 (the strike price) and immediately sell it at the market price of $115, realizing a profit of $5 per share (excluding the premium).
If the stock price falls or does not reach the strike price by the expiration date, the option expires worthless, and the maximum loss is limited to the premium paid ($5).
Uses of Call Options
Speculation: Traders often use call options to speculate on the future price movements of underlying assets. A call option allows traders to profit from rising prices without the need to purchase the asset outright.
Hedging: Investors and businesses use call options to hedge against potential price increases in their portfolios or commodities they rely on. This helps mitigate risk and protect against adverse price movements.
Income Generation: Some investors sell (write) call options to generate income. By selling call options on assets they already own, investors can receive premiums from option buyers. If the option is exercised, they sell their assets at the agreed-upon price.
Portfolio Management: Call options can be used as part of a broader portfolio management strategy to enhance returns or manage risk.