Call

What Is a Call Option?

A call option is a financial derivative contract that gives the buyer the right, but not the obligation, to purchase an underlying asset at a specified price, known as the strike price, on or before a certain date, the expiration date. For this right, the buyer pays a premium to the seller (writer) of the call option. Investors typically buy call options when they anticipate that the price of the underlying asset will increase. Conversely, sellers of call options expect the underlying asset's price to remain stable or decrease.

History and Origin

The concept of options, including agreements similar to what we now call a call, dates back to antiquity. One of the earliest accounts involves Thales of Miletus, a Greek philosopher, who, foreseeing a large olive harvest, secured the rights to use olive presses, essentially an early form of a call option, to profit from the increased demand.⁹, ¹⁰

Modern options trading, however, gained significant traction in the 20th century. A pivotal moment was the establishment of the Chicago Board Options Exchange (CBOE) in April 1973. The CBOE introduced standardized option contracts, providing a regulated and transparent marketplace for these financial instruments. This standardization, coupled with the later development of the Black-Scholes option pricing model, dramatically increased the accessibility and complexity of the options market.⁷, ⁸

Key Takeaways

• A call option grants the holder the right, but not the obligation, to buy an underlying asset.
• Buyers of call options anticipate an increase in the underlying asset's price.
• Sellers (writers) of call options expect the underlying asset's price to stay flat or decline.
• The premium is the price paid by the buyer to the seller for the call option.
• Call options are used for both speculation and hedging purposes.

Formula and Calculation

The value of a call option is influenced by several factors, including the current price of the underlying asset, the strike price, the time remaining until expiration, volatility, and interest rates. While complex pricing models like Black-Scholes are used by professionals, a simplified view of a call option's theoretical value often considers its intrinsic value and time value.

The intrinsic value of a call option is calculated as:

If the current asset price is greater than the strike price, the call option is considered in-the-money. If the current asset price is less than or equal to the strike price, the intrinsic value is zero, and the option is out-of-the-money.

Interpreting the Call Option

Interpreting a call option involves understanding the relationship between the underlying asset's price and the option's strike price. For a call option to be profitable for the buyer, the underlying asset's price must rise above the strike price by an amount greater than the premium paid. For example, if a call option has a strike price of $50 and the premium paid was $2, the underlying asset's price must exceed $52 for the buyer to realize a profit at expiration.

The deeper an option is in-the-money, the greater its intrinsic value. Conversely, an out-of-the-money call option has no intrinsic value and its value is derived solely from its time value and the potential for the underlying price to move favorably before expiration.

Hypothetical Example

Consider an investor, Sarah, who believes that Company XYZ's stock, currently trading at $95 per share, will increase in value over the next three months. To act on this belief, Sarah decides to buy a call option.

She purchases one call option contract for XYZ with a strike price of $100 and an expiration date three months from now. Each option contract typically represents 100 shares of the underlying stock. The premium for this call option is $3.00 per share, meaning Sarah pays a total of $300 ($3.00 x 100 shares) for the contract.

Scenario 1: Stock Price Increases
Three months later, Company XYZ's stock price rises to $110 per share. Sarah's call option is now in-the-money, as the current stock price ($110) is above her strike price ($100). She can exercise her right to buy 100 shares at $100 per share, then immediately sell them in the market at $110 per share.

• Value of shares purchased: 100 shares * $100/share = $10,000
• Value of shares sold: 100 shares * $110/share = $11,000
• Gross profit from trade: $11,000 - $10,000 = $1,000
• Net profit (after accounting for premium): $1,000 - $300 (premium paid) = $700

Scenario 2: Stock Price Decreases or Stays Below Strike
If, by the expiration date, Company XYZ's stock price falls to $90 or remains below $100, Sarah's call option will expire worthless. She will not exercise her right to buy at $100 since she can buy shares for less in the open market. In this case, her loss is limited to the premium paid, which is $300. This demonstrates the limited risk for the buyer and the potential for leverage when using options.

Practical Applications

Call options are widely used in various financial strategies by both individual and institutional investors.

• Speculation: Investors who are bullish on a particular stock or market index can buy call options to profit from an anticipated price increase. This offers a way to participate in upside movements with a smaller capital outlay than buying the actual shares.
• Hedging: Portfolio managers might use call options to hedge against a potential increase in the price of an asset they plan to purchase in the future, effectively locking in a maximum purchase price.
• Income Generation: Investors can write (sell) covered call options on stocks they already own to generate income from the premiums received. This strategy is often employed when an investor expects the stock price to remain relatively flat or decrease slightly.
• Leverage: Call options provide leverage because a small movement in the underlying asset's price can result in a significant percentage gain or loss on the option's value.
• Employee Compensation: Stock options, which are a form of call options, are frequently granted to employees as a form of compensation, allowing them to buy company stock at a predetermined price in the future. The Securities and Exchange Commission (SEC) provides guidance and regulations regarding employee stock options and other derivatives to ensure fair practices and transparency.

Limitations and Criticisms

While call options offer versatility, they come with certain limitations and risks:

• Time Decay: The time value component of a call option diminishes as the expiration date approaches. This "time decay" means that even if the underlying asset's price remains stable, the option's value can erode, making profitability challenging, especially for longer-term options.
• Volatility Risk: The value of a call option is highly sensitive to changes in the implied volatility of the underlying asset. A decrease in implied volatility can negatively impact the option's premium, even if the underlying price moves favorably.
• Complexity: Options trading can be complex and requires a thorough understanding of various factors, including pricing models, market dynamics, and risk management strategies. Misunderstanding these complexities can lead to significant losses.
• Liquidity: Some call options, particularly those on less actively traded stocks or with distant expiration dates, may suffer from low liquidity. This can make it difficult to enter or exit positions at desired prices. Academic research, such as the seminal paper "The Pricing of Options and Corporate Liabilities" by Fischer Black and Myron Scholes, laid the groundwork for understanding option valuation, but real-world market conditions introduce nuances not fully captured by theoretical models.⁶

Call Option vs. Put Option

A call option gives the holder the right to buy an underlying asset, reflecting a bullish outlook. In contrast, a put option gives the holder the right to sell an underlying asset at a specified strike price on or before the expiration date. Buyers of put options anticipate a decrease in the underlying asset's price, aiming to profit from a decline. Sellers of put options expect the underlying asset's price to remain stable or increase. Both call and put options are fundamental types of options contracts, but they represent opposing views on the future price direction of the underlying asset.

FAQs

How does buying a call option make money?

You make money when the underlying asset's price rises above your strike price by more than the premium you paid. You can then sell the option for a profit or exercise it to buy the shares at a lower price and immediately sell them for a higher market price.

What is the maximum loss when buying a call option?

The maximum loss when buying a call option is limited to the premium paid for the option. If the underlying asset's price does not rise sufficiently before the expiration date, the option expires worthless, and the entire premium is lost.

Can I sell a call option I bought before expiration?

Yes, most call options traded on exchanges can be sold back into the market before their expiration date. This allows you to realize any gains or cut your losses without having to exercise the option or take possession of the underlying asset. The price you receive when selling will depend on the option's current market value, which is influenced by the underlying price, time remaining, and volatility.

What is a "covered call"?

A covered call is an options strategy where an investor sells a call option while simultaneously owning an equivalent number of shares of the underlying stock. This strategy is often used to generate income from the premium received, especially when the investor believes the stock price will not rise significantly or will remain relatively flat. The "covered" aspect refers to owning the shares, which provides protection if the call option is exercised.

Are call options risky?

All investments carry risk. While buying a call option limits your potential loss to the premium paid, the probability of an option expiring worthless can be high. Call options are sensitive to factors like time decay and volatility, and their value can erode quickly if the market does not move as anticipated. Understanding these risks and employing proper risk management is crucial.¹², ³⁴, ⁵