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.
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.
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