Call option?qsrc=3044
A call option, often it is simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option.[1] The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price (see below for examples).
Call options are most profitable for the buyer when the underlying instrument moves up, making the price of the underlying instrument closer to, or above, the strike price. The call buyer believes it's likely the price of the underlying asset will rise by the exercise date. The risk is limited to the premium. The profit for the buyer can be very large, and is limited by how high underlying's spot rises. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money".
The call writer does not believe the price of the underlying security is likely to rise. The writer sells the call to collect the premium. The total loss, for the call writer, can be very large, and is only limited by how high the underlying's spot price rises.
The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.
Exact specifications may differ depending on option style. A European call option allows the holder to exercise the option (i.e., to buy) only on the option expiration date. An American call option allows exercise at any time during the life of the option.
Call options can be purchased on many financial instruments other than stock in a corporation. Options can be purchased on futures on interest rates, for example (see interest rate cap), and on commodities like gold or crude oil. A tradeable call option should not be confused with either Incentive stock options or with a warrant. An incentive stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular person (typically executives) to purchase treasury stock. When an incentive stock option is exercised, new shares are issued. Incentive stock options are not traded on the open market. In contrast, when a call option is exercised, the underlying asset is transferred from one owner to another.
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Example of a call option on a stock
An investor typically 'buys a call' when he or she expects the price of the underlying instrument will go above the call's 'strike price,' hopefully significantly 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 or she can purchase the underlying instrument at the strike price. Typically, if the price of the underlying instrument has surpassed the strike price, the buyer pays the strike price to actually purchase the underlying instrument, and then sells the instrument and pockets the profit. Of course, the investor can also hold onto the underlying instrument, if he or she feels it will continue to climb even higher.
An investor typically 'writes a call' when he or she expects the price of the underlying instrument to stay below the call's strike price. The writer (seller) receives the premium upfront as his or her profit. However, if the call buyer decides to exercise his option to buy, then the writer has the obligation to sell the underlying instrument at the strike price. Oftentimes the writer of the call does not actually own the underlying instrument, and must purchase it on the open market in order 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 purchase price of the underlying instrument and the strike price. This risk can be huge if the underlying instrument skyrockets unexpectedly in price.
- The current price of ABC Corp stock is $45 per share, and investor 'Chris' expects it will go up significantly. Chris buys a call contract for 100 shares of ABC Corp from 'Sumner,' who is the call writer/seller. The strike price for the contract is $50 per share, and Chris pays a premium upfront of $5 per share, or $500 total. If ABC Corp does not go up, and Chris does not exercise the contract, then Chris has lost $500. However, ABC Corp stock does go up -- to $60 per share before the contract is expired. Chris exercises the call by buying 100 shares of ABC from Sumner, for a total of $5,000. Chris sells the stock in the market, at a total price of $6,000. Chris has paid a $500 contract premium plus a stock cost of $5000, for a total of $5500. Chris has earned back $6000, for a net profit of $500. Sumner, however, did not do so well. Sumner did not already own ABC Corp stock, so when Chris exercised the contract Sumner had to buy the stock on the open market, at $6000. Sumner had already earned the $500 premium for the contract, so the total loss for Sumner was $500.
- What if ABC stock price had dropped to $40 per share? Chris would not have exercised the option. (Why buy a stock at $50 per share from Sumner when Chris could buy it on the open market at $40 per share?) Chris would have lost his premium, a total of $500. Sumner, however, would have earned the premium with no other out of pocket expenses, for a profit of $500.
These examples show that a call option has positive monetary value to the buyer (that is, offers the chance for a profit) only when the underlying instrument has a spot price (S) above the strike price (K). Since the option will not rationally be exercised unless it is "in-the-money", the payoff for a call option is
- max[(S − K),0]
also written
where
Option values vary with the value of the underlying instrument over time. The price of the call contract must reflect the "likelihood" or chance of the call finishing "in-the-money." The call contract price generally will be higher when the contract has more time to expire (except in cases when a significant dividend is present) and when the underlying financial instrument shows more volatile. Determining this value is one of the central functions of financial mathematics. The most common method used is the Black-Scholes formula. Whatever the formula used, the buyer and seller must agree on the initial value (the premium or price of the call contract), otherwise the exchange (buy/sell) of the call will not take place.
Options
- Binary option
- Bond option
- Credit default option
- Exotic interest rate option
- Foreign exchange option
- Interest rate cap and floor
- Options on futures
- Stock option
- Swaption
- Warrant (finance)
See also
References
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