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What is a Call Option?

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  • Written By: John Sunshine
  • Edited By: Niki Foster
  • Last Modified Date: 24 July 2014
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A call option is a type of financial instrument known as a derivative. It is basically an agreement between two parties to exchange ownership of a stock at an agreed upon price within a certain time period. The exchange of the stock is optional and the owner of the option decides whether it takes place.

The agreed upon price of the exchange is called the strike price. The date on which the agreement expires is the expiry date of the call option. The amount of money required to purchase this option is called the premium. If the exchange takes place, then one is said to have exercised the call option.

Premiums for this kind of derivative are always quoted per stock, but sold in lots of 100 shares minimum. Call options are always an agreement about being able to purchase the stock at the agreed upon price. They come in both European style and American style. The main difference between these two is that European options can only be exercised on the expiry day, while American style options can be exercised at any time during their life.

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Call options are frequently described by the relationship of the strike price to the stock price. One for which the strike price is equal to the stock price is said to be at the money. If the strike price is above the stock price, the option is said to be out of the money. Finally, if the strike price is less than the stock price, the option is said to be in the money.

There are two investment styles when investing in these derivatives. Conservative investors sell an out of the money call option on a stock that is part of their portfolio to increase the overall return on their portfolio. The intention is that the stock price will not increase at such a rate that it becomes equal to or greater than the strike price. In this case, the investor gets to keep the premium and the stock, and the option expires worthless. The process will then be repeated.

The speculative investor will purchase at the money call options without owning the underlying stock. The expectation is that the price of the option will increase as the price of the stock increases. Typically, if the stock price increases by one US dollar (USD), the price of the option will also increase by one USD. However, since the call option may cost as little as one tenth of the stock, the rate of return on the investment is much higher than it would be if the stock were purchased.

For example, if the stock cost $10 USD, then the call option for this stock for a 10 USD strike price could cost 1 USD. If the stock were to increase in price to 11 USD, the profit with the stock purchase is 1 USD and equal to a 10% return; however, the call option profit is also $1 USD, and since only 1 USD was invested, a 100% return is realized. However, if the price were to drop to 9.50 USD, the option would become worthless and the entire $1 USD investment would be lost, while only $0.50 USD would be lost with the stock purchase. With the leverage, this type of derivative provides that gains are magnified, but losses are as well. The stock owner would also receive any dividends paid out, while the owner of a call option would not.

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Discuss this Article

John57
Post 7

Options are not any less risky to trade than they have been in the past, but there are a lot more opportunities to gather information about them than there used to be. I remember going through the newspaper to look at strike prices and expiration dates.

The internet has really made trading much easier to do. I enjoy online trading. Many people have no idea what it is like to have to physically call a broker to make every trade.

I use some of the online call option calculators to help me look at the spread and determine expiration date and strike price to go with. Having access to tools like this can help give you a clearer picture of your risk.

julies
Post 6

One of the advantages of trading call options is that you can know exactly how much your risk is. If the option expires and the stock has not risen in price, you are only out the amount of money you used to purchase the option.

It just depends on how much premium you want to pay and how far away from the strike price you feel comfortable going. I have been fairly successful doing some options trading, but often get frustrated when the stock just doesn't move as fast as I would like it to.

There are so many different ways to play options that you can risk as much or as little as you are comfortable with. The greater the risk, the greater reward you will usually have. If you like to play it safer, you may want to stay away from options altogether.

golf07
Post 5

Trading options always has its risk and the time factor usually makes it even tougher. With that being said, if there is a stock that you really want to trade and can't afford the high price, a call option may something to consider.

You buy a call option when you think the stock price is going to rise. What you have to consider before making your purchase is when the option expires. This is one reason trading stock options is riskier than trading the stock. If the price of the stock goes the opposite way you intend, you always have the option of waiting until it goes the other way.

You can't do this with options, because of their expiration date. You need to allow yourself enough time for the stock to increase in value before it gets too close to expiration or you won't make any money.

anon21142
Post 2

what is the effect of interest rate on call option?

anon21086
Post 1

In call option, the buyer has determined a date which is also called expiry date. So till that date is he liable to pay or receive something as premium?

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