Definition
A call option, often simply labeled a “call”, is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument from the seller of the option at a certain time for a certain price. The seller is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee for this right. The term “call” comes from the fact that the owner has the right to “call the stock away” from the seller.
Call Option
What is a ‘Call Option’
A call option is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period.
Explaining ‘Call Option’
Call options are typically used by investors for three primary purposes. These are tax management, income generation and speculation.
How Options Work
An options contract gives the holder the right to buy 100 shares of the underlying security at a specific price, known as the strike price, up until a specified date, known as the expiration date. For example, a single call option contract may give a holder the right to buy 100 shares of Apple stock at a price of $100 until Dec. 31, 2017. As the value of Apple stock goes up, the price of the options contract goes up, and vice versa. Options contract holders can hold the contract until the expiration date, at which point they can take delivery of the 100 shares of stock or sell the options contract at any point before the expiration date at the market price of the contract at the time.
Options Used for Tax Management
Investors sometimes use options as a means of changing the allocation of their portfolios without actually buying or selling the underlying security. For example, an investor may own 100 shares of Apple stock and be sitting on a large unrealized capital gain. Not wanting to trigger a taxable event, shareholders may use options to reduce the exposure to the underlying security without actually selling it. The only cost to the shareholder for engaging in this strategy is the cost of the options contract itself.
Options Used for Income Generation
Some investors use call options to generate income through a covered call strategy. This strategy involves owning an underlying stock while at the same time selling a call option, or giving someone else the right to buy your stock. The investor collects the option premium and hopes the option expires worthless. This strategy generates additional income for the investor but can also limit profit potential if the underlying stock price rises sharply.
Options Used for Speculation
Options contracts give buyers the opportunity to obtain significant exposure to a stock for a relatively small price. Used in isolation, they can provide significant gains if a stock rises, but can also lead to 100% losses if the call option purchased expires worthless because the underlying stock price went down. Options contracts should be considered very risky if used for speculative purposes because of the high degree of leverage involved.
Further Reading
- Tests of the Black-Scholes and Cox call option valuation models – www.jstor.org [PDF]
- An empirical examination of the Black-Scholes call option pricing model – www.jstor.org [PDF]
- Anticipated information releases reflected in call option prices – www.sciencedirect.com [PDF]
- Determinants of the call option on corporate bonds – www.sciencedirect.com [PDF]
- Real-options valuation for a biotechnology company – www.tandfonline.com [PDF]
- Call option pricing when the exercise price is uncertain, and the valuation of index bonds – www.jstor.org [PDF]
- The guaranteed maximum price contract as call option – www.tandfonline.com [PDF]
- Transaction data tests of S&P 100 call option pricing – www.cambridge.org [PDF]
