What is a Call Option?
A call option is a type of derivative which outlines an agreement between two parties who are contractually obligated to exchange ownership of a specific stock at an agreed upon price within a certain time period. The exchange of the stock is optional and the owner of the call contract decides whether or not it will take place.
The agreed upon price of the call option is referred to as the strike price. Every option contract has an expiration date which signifies the termination of the contract. Additionally, the amount of money required to purchase a call option is called the premium. If the exchange of the stock takes place before the expiration date, the contract is said to have been exercised by the parties involved in the agreement.
Call options are quoted per stock and are sold in lots of 100 shares. These types of option agreements are outlined with the notion that the purchasing party has the ability to purchase the underlying stock at the agreed upon price.
There are two distinct types of call options:
American call options and European call options. Both forms of contractual agreements possess the same fundamental characteristics; however, a European call option can only be exercised on the expiration date, while an American style option can be exercised at any time during the life of the call option, meaning any time before the expiration date passes
Call options are typically described based on the relationship of the underlying equities share price and the strike price of the option contract. Call options that exhibit a price relationship where the strike price is equal to the price of the stock are said to be “at the money.” If the strike price is higher than the stock price, the call option is “out of the money” Lastly, if the strike price is less than the stock price, the call option is “in the money.”
An investor will typically purchase a call option when he or she expects the price of the underlying equity to rise above the option’s strike price before the contract expires. The investor, when purchasing a call option, will pay a non-refundable premium for the legal authority to exercise the call at the strike price; this simply means that the investor can purchase the underlying instrument once it has surpassed the strike price. In most cases, if the price of the underling equity has surpassed the strike price, the buyer will pay the agreed-upon strike price to purchase the underling equity and then sells the stock to generate a profit.
In this instant, the investor also has the right to hold the underlying stock if he or she feels it will continue to increase in value.
An investor, in contrast, will write a call when he or she expects the price of the underlying equity to stay below the call’s strike price. The writer of the call will receive a premium as his or her profit; however, if the call buyer decides to execute the right to purchase the option, the writer has the obligation to sell underlying equity at the strike price.
In most relationships, the writer of the call does not own the underlying equity and must purchase it on the open stock market to be able to sell it to the buyer of the call. In this instance, the seller of the call will lose the difference between his or her purchase price of the underlying equity and the agreed upon strike price. As a result, the risk can be tremendous if the underlying stock skyrockets in price.