A call option , often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The seller or "writer" is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee called a premium for this right. The term "call" comes from the fact that the owner has the right to "call the stock away" from the seller.
When you buy a call option, you are buying the right to buy a stock at the strike price, regardless of the stock price in the future before the expiration date. Conversely, the seller can short or "write" the call option, giving the buyer the right to buy that stock from you anytime before the option expires. To compensate you for that risk taken, the buyer pays you a premium, also known as the price of the call.
The seller of the call is said to have shorted the call option, and keeps the premium the amount the buyer pays to buy the option whether or not the buyer ever exercises the option. When the price of the underlying instrument surpasses the strike price, the option is said to be " in the money ". If this occurs, the option expires worthless and the option seller keeps the premium as profit.
The payoff is as scaled and shifted ramp function , frequently referred to as a hockey stick , due to the resemblance to an ice hockey stick. Since the payoff of purchased call options increases as the stock price rises, buying call options is considered bullish.
Conversely, since the payoff for sold or written call options increases as the stock price falls, selling call options is considered bearish. Exact specifications may differ depending on option style. A European call option allows the holder to exercise the option i. 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 or 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 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. An investor typically 'buys a call' when he 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 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 feels it will continue to climb even higher. An investor typically 'writes a call' when he expects the price of the underlying instrument to stay below the call's strike price. The writer seller receives the premium up front 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.
Often 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 purchase price of the underlying instrument and the strike price. This risk can be huge if the underlying instrument skyrockets unexpectedly in price.
A company issues an option for the right to buy their stock. An investor buys this option and hopes the stock goes higher so their option will increase in value. The call premium tends to go down as the option gets closer to the call date. And it goes down as the option price rises relative to the stock price, i. The lower percentage of the option's price is based on the stock's price, the more upside the investor has, therefore the investor will pay a premium for it.
Or it can be held as the investor bets that the price will continue to increase. The investor must make a decision by January If the stock price drops below the strike price on this date the investor will not exercise his right since it will be worthless.
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 volatility.
Determining this value is one of the central functions of financial mathematics. The most common method used is the Black—Scholes formula. Importantly, the Black-Scholes formula provides an estimate of the price of European-style options. Adjustment to Call Option: When a call option is in-the-money i. Some of them are as follows:.
Similarly if the buyer is making loss on his position i. Trading options involves a constant monitoring of the option value, which is affected by the following factors:. Moreover, the dependence of the option value to price, volatility and time is not linear — which makes the analysis even more complex. From Wikipedia, the free encyclopedia. This article is about financial options. For call options in general, see Option law. This article needs additional citations for verification.
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