Finance

Call Option

Call Option

An option is a contract that allows an investor to buy or sell an underlying instrument like a security, ETF, or even an index at a predetermined price over a certain period of time. Buying and selling of options take place in the options market, which trades contracts based on securities. Buying an option that allows you to buy shares at a later time is called a call option and buying an option that gives the buyer the right to sell but no the obligation is called put option.

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Simply buying or selling the option doesn’t mean that the option needs to be exercised at the buying selling time because the system options are considered derivative securities which means that their price is derived from an underlying asset. For this very reason, options are considered less risky than stocks.

What is a Call Option?

A call option is a form of derivative contract that gives the call option buyer the right but not the obligation to buy the stock or any other financial instrument at a specific price which is the strike price of the option within a specified time frame. The seller of the option is obligated to sell the security to the buyer if the latter decides to exercise their option to make a purchase. The buyer of the option can exercise the options any time prior to the specified expiration date which can be three months, six months, or even a year in the future. The price of the option is based on how likely or unlikely it is that the option buyer will have a chance to profitable exercise the option prior to the expiration. Usually, options are sold in lots of 100 shares.

How Call Options Work?

As call options are derivative instruments their price is derived from the price of an underlying asset such as a stock. For example, if a buyer purchases the call option of ABC at a strike price of $100 and with an expiration date of December 31, they will have the right to buy 100 shares of the company anytime before December 31. The buyer can also sell the options contract to another option buyer at any time before expiration at the prevailing market price of the contract. If the prices of the asset remain stable over a period of time or decline in value then the value of the option will decline as it nears its expiration date. Call options can also be used for speculations and hedging.

Explain the payoff for Call Buyer and Call Seller:

The payoff on a call option to the option buyer is calculated as follows-

CT = max(0, ST – X)

Where,

CT = payoff on a call option

ST = stock price at maturity

X = strike price of the option

The price paid for the call option, C0 is the call premium.

PROFIT = CT – C0

Where,

Ct = payoff on call option

C0 = call premium

The payoff on a call option to the option seller is calculated as follows-

CT = max(0, X – ST)

PROFIT = C0 – CT

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Example:

Microsoft shares are trading at $108 per share. Mr. A owns 100 shares of the stock and wants to generate an income above and beyond the stock’s dividend. He also believes that the shares are unlikely to rise above $115 per share over the next month. He looks through call options and finds that there is 115-call trading at $0.37 per contract. So, he can sell one call option and collect a premium of $37($0.37 * 100). If the stock rises above $115 the option buyer will exercise the option and Mr. A will have to deliver 100 shares of the stock at $115 per share but he has still generated a profit of $7 per share but has missed out on any upside above $115. If the stock does not rise above $115, he can keep the shares and the $37 in premium income.

Final Thoughts:

Call options are often used for income generation, speculation, and tax management. Buying call options enable investors to invest a small amount of capital to potentially profit from a price rise in the underlying security or to hedge away from positional risks. Small investors use options to try to earn small amounts of money into big profit’s while corporate and institutional investors use options to increase their marginal revenues and hedge their stock portfolios. It is very important to fully understand an option contract’s value and profitability while considering a trade.

Author -Sanjana Rau

About the author- Started my journey of self even when the odds were against me, keen observation, a cool temper, and sports worked the best for me.

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