Definition
The term call option refers to a financial contract that gives the investor the right to purchase a security at a specified price before the agreement expires. A call option is not an obligation to purchase the security; it merely provides the holder with the right to purchase it.
Explanation
Also referred to as simply a call, a call option is an arrangement between two parties that provides the holder with the right to "call in," or buy, an agreed-to number of securities at a specified price, and within a given timeframe. Call options typically involve securities such as stocks and bonds, as well as commodities.
The seller of a call option is referred to as the writer, who is obligated to sell the securities to the holder of the call option if they exercise their right. The buyer of a call pays a fee, known as a premium, to own the right to exercise their option. Every call option has at least three important features the buyer needs to be familiar with:
Premium: this is the cost the buyer of the call pays to own the option. It is also the price received by the writer.
Strike Price: also known as the exercise price, this is the cost of the security if the holder of the call decides to exercise their right to buy it.
Expiry Date: this is the date the option expires if the holder decides they don't want to exercise their right to purchase the security.
A call option that is in-the-money has real value to the investor. This happens when the strike price is below the current market price of the underlying security. Generally, the buyer of a call option is bullish on the security, since they believe its price will increase over time. The writer of the call option has a bearish view. They write the call option because they believe the price of the security will fall over time.
Example
Company ABC's stock is currently trading at $10.00 per share. An investor believes this stock is undervalued, so they purchase a call option for 100 shares of stock with a strike price of $10.00, expiring in one month. The premium was $0.50 per share, so the investor paid $0.50 x 100 shares, or $50.00, for the call option. Three weeks later, the price of Company ABC's stock rises to $12.50, and the investor decides to exercise their right to call in 100 shares of stock. The investor then immediately sells the stock for $12.50 on the exchange. The profit realized by the investor in this example would be:
= Market Price of Stock - Purchase Price - Premium = $12.50 x 100 shares - $10.00 x 100 shares - $50.00 = $1,250 - $1,000 - $50.00, or $200
Related Terms
- The term naked call refers to a strategy in which the seller of a call option does not own the underlying securities outlined in the contract. Naked calls are considered an advanced options strategy, since it carries unlimited risk.
Moneyzine EditorSeptember 20th, 2023 - The term put option refers to a financial contract that gives the investor the right to sell a security at a specified price before the agreement expires. A put option is not an obligation to sell the security; it merely provides the holder with the right to sell it.Moneyzine EditorSeptember 21st, 2023
The term covered call refers to a strategy in which the seller of a call option owns all of the underlying securities outlined in the contract. Investors will do this when they do not believe the asset will increase in value over time, and would like to profit from the option premium.Moneyzine EditorJanuary 12th, 2024- The term naked put refers to a strategy in which the writer of a put option does not own the underlying securities outlined in the contract. Naked puts are considered an advanced options strategy, since they carry considerable risk, which is only second to naked calls.Moneyzine EditorSeptember 20th, 2023
