What is a Call Option?

Published by Thomas Herold in Investments

'Call Option' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

A call option is a contract that grants a person the right, and yet not the requirement, to purchase a given security at a certain price by a certain cut off time. The securities that have call options associated with them are generally stocks, commodities, bonds, and certain other instruments. Call options are commonly abbreviated as simply calls.

In practice, call options are regulated financial contracts made between a buyer and a seller of the particular option. The purchaser of such a call is given the right to buy a set amount of the underlying instrument or commodity in question from the party selling the call option at a particular time, which is the expiration date, and at a particular price, which is called the strike price. The seller binds himself or herself to selling the underlying commodity or financial issue if the buyer wishes to obtain it. For this opportunity, the buyer pays a premium, or a fee.

Purchasers of call options are hoping that the underlying commodity or instrument’s price will go up in the future. Sellers hope that such a price will not rise. Otherwise, a seller may be agreeable to give away a portion of the rise in price in exchange for the premium that is paid to them upfront. The seller still has the opportunity to make any profits that exist all the way up to the particular strike price.

For buyers, call options prove to be at their greatest profitability as the instrument that underlies them goes up in price. The goal of a buyer is for the underlying instrument’s price to approach, or rise over, the actual strike price. The purchaser of the call feels that the chances are good that the underlying asset’s price will increase by the expiration or exercise date of the option. The risk of this happening influences the value of the premium paid.

Profits made on call options can be substantial. They are only restricted by how high the price of the underlying commodity or instrument can go. Options become in the money as the underlying instrument price exceeds the specified strike price. When they reach the strike price, such options are said to be at the money.

For a call writer, or seller, who does not own the underlying commodity or instrument, selling a call entails an unlimited amount of risk potential. The call writer sells such a call in order to obtain a premium. Losses for such sellers can be enormous, and are only limited to how high the price of the underlying instrument can rise.

Call options may be bought on a wide variety of instruments besides stocks in a company. You can buy options on interest rate futures or commodities such as oil, gold, and silver. There are also two different sets of rules for exercising call options. European call options permit option holders to exercise an option on just its date of expiration, while American call options give the owner this ability to do so at any time in the option’s life span.

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The term 'Call Option' is included in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.