Call Option

A call option is a financial contract that permits but does not obligate a buyer to purchase an underlying asset at a predetermined (strike) price within a specific period (expiration). It occurs when an investor predicts that the price of a stock, bond, or commodity will rise in the future to profit.

From entering this derivative contract, the buyer pays a premium until exercising it. If the underlying asset price rises, the buyer makes a profit. But if the price falls, the contract expires worthless, and the seller collects the premium. Investors chose this option to improve income, reduce risk, plan investments, and manage taxes.

• Call option meaning describes a financial contract that allows but does not compel a buyer to buy an underlying asset at a predefined price within a certain time frame. However, if the buyer exercises the option, the seller must sell the asset.
• The buyer benefits from a price increase (speculation) or subsequently hedging to reduce positioning risks. The seller earns money from the contract's premiums.
• It normally necessitates the purchase of 100 shares at once. The buyer pays a premium from when they enter this derivative contract until they exercise it.
• It is the inverse of a put option, which allows the seller to sell the underlying asset at a predetermined price on or before the expiration date.

Call option trading lets the buyer purchase an asset at a discounted price if handled carefully. In other words, they can buy the desired asset at a predetermined price for a specific period, but it is not an obligation in any manner. It is the polar opposite of a put option, where the seller can sell the underlying asset at a predetermined price on or before the expiration date.

When trading stocks, bonds, commodities, or any other financial instrument, the goal is to profit from a price increase (speculation) or reduce positioning risks (hedging) later. The buyer hopes the upward movement of prices does not impact their buying decision through this option.

Buyers and sellers enter into call option contracts via a brokerage firm, which is a middleman. It usually requires trading 100 shares at once. It can be long (buying) or short (selling). The strike price for the asset is what the seller comes up with for a specific period. If a buyer agrees on that price and date, the broker connects them with the seller. Both parties remain anonymous, and the broker does everything is necessary to fulfill the arrangement. The buyer must pay a premium to demonstrate their commitment to the contract.

In the call option, the seller sets the strike price, but it is up to the buyer to agree or disagree.

Let us say a seller sets a strike price of $5 per share or $500 for 100 shares in a call option. On the other hand, the buyer speculates that prices would eventually rise to $10 and agrees to the contract expiring in March 2022.

Even if the price rises to $8 until March 2022, the buyer will still honor the deal and make a profit. On the other hand, the buyer can choose not to exercise the contract if the current market price falls below $5 per share and will lose the premium.

• Does not obligate the buyer to buy the underlying asset but requires the seller to sell the asset if the former exercises the options contract.
• The time to exercise the option to buy the asset can be three months-1 year before contract maturity.
• Allows the trader to exercise the option, let the option expire, or sell the option depending on their option trading strategy.
• At expiration, if the underlying asset price rises above the strike price, the buyer makes a profit minus premium, whereas if it falls, the buyer loses the premium.
• The seller collects the premium in either case.

As mentioned below, there are two sorts of call options:

#1 Long

In this case, the buyer has the right, but not the obligation, to purchase an asset at a future strike price. A key advantage of this option is that it enables a buyer to plan ahead and buy the asset at a lower price. A lot of traders place such a call on stocks with high dividend yield as share prices usually surge as the ex-date or ex-dividend date nears. After that, on that date, the price decreases. One must note that the long call holders receive the dividend only when they choose to exercise the option prior to that specific ex-date.

Let us look at the following graph to understand the concept of long call options better.

#2 Short

In the case of short call options, the seller promises the buyer to sell shares at a set strike price in the future. As the name suggests, these are the exact opposite of long call options. Generally, option sellers utilize them for covered calls. Alternatively, they may utilize these for call options where they already have ownership of the underlying asset for their options.

Let us look at the following short call option graph to better understand the concept.

Let us look at the following behavioral call option example to understand how it works:

Jim is interested in purchasing Google stock, trading at $130 per share. He speculates that prices would rise to $140. But Jim does not have enough money to acquire the shares. So, he enters into a three-month contract to purchase 100 shares for $13,000.

Jim realizes that his predictions were incorrect before the expiration date but waits until maturity. The Google stock price rises to $134 per share on the expiration date. Jim continues to buy Google stock, gaining $4 per share, for a total profit of $400 on one call option.

The buyer decides to buy a call option after ensuring that a company's stock value will rise in the future. It, thus, is never a loss for them. Next, investors (holders) enter into the contract to be settled on a future date at a fixed strike price, anticipating a price rise in the future. Finally, the brokerage firm matches them with the seller with similar preferences for further processing.

If the underlying asset price rises above the strike price at expiration, the buyer can purchase the asset at a reduced price as agreed upon in the contract. Conversely, if prices fall, the buyer has the opportunity to cancel the contract as it is not legally enforceable or obligated. Therefore, it is a win-win ‘bullish’ deal for buyers.

Here, the seller, also referred to as a call option writer, seeks to profit by selling assets at the maximum possible price, i.e., as much below the strike price as possible. They want the asset price to fall or keep their shares safe until they get the best price, even after entering the contract. In other words, they want buyers to cancel the contract and buy on the open market if prices remain low until the expiration date.

When the buyer discovers that the asset's market value is less than the predetermined price, they cancel the purchase. Meanwhile, the seller profits handsomely from the premiums that interested buyers paid for the assets. If on the expiration date, the market price of the asset is higher than the strike price, the buyer purchases it at the set price.

Even while the seller earns a substantial sum for 100 shares, they miss out on a better deal if the stock value would have risen. Additionally, they have no premium amount to collect from the contract. And above everything else, they lose all their shares. As a result, it is a 'bearish' situation for sellers.

Types of Sell Call Options

There are two ways to sell call options:

1. Covered: Here, the seller genuinely owns the underlying asset and is protected from a loss if the buyer exercises their option and purchases it.
2. Naked: Here, the seller, who does not own the underlying asset, can sell it, but in doing so, they are not protected against potential losses.

This has been a guide to call option and meaning. Here we explain how does call option works along with features, examples, and types. You may also learn more about financing from the following articles -

• Call Options vs Put Options
• Options Trading
• Put-Call Ratio