What Is a Call Option?
A call option is a financial 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 particular date (the expiration date). As a type of derivative, its value is derived from the price movements of an underlying asset, which can be a stock, commodity, or index. Buyers of call options typically anticipate that the price of the underlying asset will increase, allowing them to profit from the appreciation. Conversely, the seller, or "writer," of a call option takes on the obligation to sell the underlying asset if the buyer chooses to exercise the option. Call options are fundamental instruments in options trading and fall under the broader category of derivatives trading.
History and Origin
The concept of options has roots stretching back centuries, with unlisted, bilaterally negotiated options trading in the United States as early as the 1790s. Prior to the formalization of options exchanges, these contracts were traded over-the-counter (OTC) and were not widely used. A significant turning point in the history of financial markets came with the establishment of the Chicago Board Options Exchange (CBOE). The CBOE opened its doors on April 26, 1973, becoming the first marketplace to list standardized, exchange-traded stock options. This innovation introduced uniform contract terms, centralized liquidity, and a dedicated clearing entity, transforming the landscape for derivatives. Initially, only call options were traded, with the trading of put options approved several years later.6, 7
Key Takeaways
- A call option grants the holder the right to buy an underlying asset at a set price by a specific date.
- Buyers of call options expect the price of the underlying asset to rise.
- Sellers (writers) of call options are obligated to sell the underlying asset if the option is exercised.
- Call options are leveraged instruments, meaning a small investment can control a larger amount of the underlying asset.
- The maximum loss for a call option buyer is limited to the premium paid.
Formula and Calculation
The theoretical price 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, the volatility of the underlying asset, the risk-free interest rate, and any dividends expected. While complex pricing models like the Black-Scholes model are used by professionals, the profit or loss for a call option buyer at expiration can be simply calculated.
For the buyer of a call option:
If the current stock price is less than the strike price, the option expires out-of-the-money, and the loss is limited to the premium paid. If the current stock price is greater than the strike price, the option is in-the-money, and the buyer may exercise for a profit. The intrinsic value of a call option is the greater of (underlying asset price - strike price) or zero.
Interpreting the Call Option
Interpreting a call option largely revolves around its relationship to the underlying asset's price relative to the strike price and the time remaining until expiration. A call option becomes more valuable as the underlying asset's price rises above the strike price. Conversely, its value diminishes as the underlying price falls below the strike price or as the time value erodes closer to expiration. Investors typically interpret buying a call option as a bullish bet on the underlying asset. The higher the premium an investor is willing to pay, the stronger their belief in a significant upward price movement or higher expected volatility.
Hypothetical Example
Consider an investor, Sarah, who believes that shares of Company XYZ, currently trading at $50, will increase in value. She decides to purchase a call option with a strike price of $55 and an expiration date three months away. The premium for this call option is $3.00 per share. Since each option contract typically represents 100 shares, the total cost to Sarah is $3.00 * 100 = $300.
After two months, Company XYZ's stock price rises to $65 per share. Sarah's call option is now significantly in-the-money. She can choose to exercise her option, buying 100 shares of Company XYZ at the strike price of $55 per share and immediately selling them in the market at $65 per share.
Her profit would be calculated as:
(($65 \text{ (Market Price)} - $55 \text{ (Strike Price)})) * 100 shares - $300 \text{ (Premium Paid)} = (($10)) * 100 - $300 = $1,000 - $300 = $700.
Alternatively, Sarah could sell her call option on the open market before expiration, as its value would have increased due to the rise in the underlying asset's price.
Practical Applications
Call options serve various purposes for investors and traders in financial markets. One primary application is speculation. Investors use call options to capitalize on anticipated upward price movements in an underlying asset, potentially achieving higher percentage returns compared to directly buying the shares, due to the leverage options provide. For instance, an investor might buy a call option on a stock expecting a positive earnings report.
Another common use is hedging. While buying a call option isn't typically used for hedging an existing long stock position (that would be a put option), selling a covered call (writing a call option against shares already owned) can generate income or provide a limited hedge against a small decline in the stock's price. Financial professionals also employ call options in complex strategies, such as spreads and combinations, to manage risk or tailor exposure to specific market outlooks. The Federal Reserve Bank of San Francisco has noted the role of derivatives, which include options, in reflecting market expectations and influencing financial market conditions.5
Limitations and Criticisms
Despite their utility, call options come with significant limitations and risks. For the buyer, the primary risk is that the option may expire worthless if the underlying asset's price does not move above the strike price before expiration. In such cases, the entire premium paid for the call option is lost.3, 4 This risk is particularly pronounced with short-dated options, where there is less time for the underlying asset's price to move favorably.
For the seller (writer) of an uncovered or "naked" call option (where they do not own the underlying shares), the potential for loss is theoretically unlimited. If the underlying asset's price skyrockets, the seller is obligated to deliver shares at the strike price, which could result in substantial losses if they have to buy those shares at a much higher market price to fulfill the obligation. This can also trigger a margin call from their brokerage firm. Due to these significant risks, options trading is not suitable for all investors, and extensive understanding of the rights, obligations, and inherent risks is crucial.1, 2
Call Option vs. Put Option
The distinction between a call option and a put option lies in the right they convey and the market outlook they typically represent. A call option gives the holder the right to buy the underlying asset, and its value generally increases when the underlying asset's price rises. Buyers of call options are typically bullish, expecting an upward price movement.
In contrast, a put option grants the holder the right to sell the underlying asset at a specified strike price on or before the expiration date. Its value generally increases when the underlying asset's price falls. Buyers of put options are typically bearish, expecting a downward price movement. While both are types of options contracts used for speculation, hedging, and income generation, their directional bets on the underlying asset are diametrically opposed.
FAQs
What does it mean if a call option is "in the money"?
A call option is considered in-the-money when the current price of the underlying asset is higher than the option's strike price. This means the option has intrinsic value and would be profitable to exercise immediately.
Can you lose more than you invest when buying a call option?
When you buy a call option, your maximum potential loss is limited to the premium you paid for the option, plus any trading commissions. You cannot lose more than this amount, even if the underlying asset's price drops to zero. However, selling (writing) an uncovered call option carries potentially unlimited risk.
How does volatility affect a call option's price?
Generally, an increase in the expected future volatility of the underlying asset will lead to a higher premium for a call option. This is because greater volatility increases the probability that the underlying asset's price will move significantly above the strike price before the expiration date, making the option more valuable.