Call option

A call is a financial contract that gives the buyer the right, but not the obligation, to purchase a specific quantity of an underlying asset at a predetermined price (the strike price) within a specified period (until expiration), in exchange for a premium paid to the seller.
Written by
Reviewed by
Updated on Jun 3, 2024
Reading time 4 minutes

3 key takeaways

Copy link to section
  • A call option provides the holder with the opportunity to profit from an increase in the price of the underlying asset above the strike price.
  • The buyer of a call option pays a premium to the seller, which represents the cost of acquiring the option contract.
  • Call options can be used for speculative purposes, hedging against price fluctuations, or implementing trading strategies to generate income or manage risk.

What is a Call Option

Copy link to section

A call option is a derivative contract that grants the buyer the right, but not the obligation, to buy a specified quantity of the underlying asset from the option seller (or writer) at the predetermined strike price within a specified time frame, known as the expiration date. Call options are commonly used in financial markets to speculate on the future price movement of stocks, commodities, currencies, or other financial instruments.

Importance of Call Options

Copy link to section
  • Price Speculation: Call options allow investors to profit from potential price increases in the underlying asset without having to own the asset outright, providing leverage and potential higher returns on investment.
  • Risk Management: Call options can be utilized as part of risk management strategies to hedge against adverse price movements in the underlying asset, providing downside protection and limiting potential losses.
  • Portfolio Diversification: Incorporating call options into an investment portfolio can enhance diversification and provide additional sources of potential returns, allowing investors to tailor their risk-return profiles to suit their investment objectives.

How Call Options work

Copy link to section

Option Premium

The buyer of a call option pays a premium to the seller (writer) of the option at the time of purchase. The premium represents the cost of acquiring the option contract and is determined by factors such as the current price of the underlying asset, the strike price, the time remaining until expiration, and market volatility.

Exercise and Expiration

Call options can be exercised by the buyer at any time before the expiration date, allowing them to buy the underlying asset at the agreed-upon strike price. If the option is not exercised by expiration, it expires worthless, and the buyer loses the premium paid.

Profit Potential

The profit potential for a call option buyer is unlimited, as the value of the option increases with any rise in the price of the underlying asset above the strike price. However, the maximum loss for the buyer is limited to the premium paid for the option contract.

Examples of Call Options

Copy link to section
  • Stock Call Option: An investor purchases a call option on shares of Company XYZ with a strike price of $50 and an expiration date in three months. If the stock price rises above $50 before expiration, the investor can exercise the option to buy the shares at $50, potentially profiting from the price increase.
  • Commodity Call Option: A trader buys a call option on crude oil futures with a strike price of $60 per barrel and an expiration date in one month. If the price of crude oil rises above $60 per barrel before expiration, the trader can exercise the option to buy oil futures at $60, benefiting from the price appreciation.

Real world application

Copy link to section

In real-world trading scenarios, call options are widely used by investors, traders, and institutions for various purposes, including speculation, risk management, and portfolio optimization. For example, individual investors may purchase call options on stocks to capitalize on anticipated price movements, while institutional investors may use call options as part of complex trading strategies or hedging programs to mitigate risk exposure in their portfolios.

Moreover, call options play a crucial role in financial markets by providing liquidity, price discovery, and risk transfer mechanisms, contributing to market efficiency and functioning. Understanding the mechanics and applications of call options is essential for market participants to make informed investment decisions, manage risk effectively, and navigate dynamic market conditions.


Sources & references

Arti

Arti

AI Financial Assistant

  • Finance
  • Investing
  • Trading
  • Stock Market
  • Cryptocurrency
Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000 Invezz related data points, has read every piece of research, news and guidance we\'ve ever produced, and is trained to never make up new...