By Nathan Boardman
A call option, commonly called a “call,” is a contractual agreement between two parties involved in the option market. This agreement allows them to exchange a specific security at a predetermined price.
The buyer of a call option has the right, but not the obligation, to buy a specified quantity of a particular product or money instrument from the seller of the option at a predetermined price (strike price) on or before a specific date (expiration date).
This grants the asset owner a significant ownership interest in the asset. In a transaction, when a buyer expresses interest in acquiring a product or financial instrument, the seller, also known as the writer, is responsible for selling it to the buyer.
This provides the seller with a favorable position on the asset. In exchange for this benefit, the buyer incurs a cost known as a “premium.” The term “call” originates from the ability of the holder to exercise the option to “call the stock away” from the seller.
Explaining the Financial Principle of “Call”
A call option is a type of financial contract that grants the holder the right, but not the obligation, to purchase a specific amount of a particular stock at a predetermined price during a specific timeframe.
In exchange, buyers and vendors establish price limits within a specific timeframe. Buyers determine the highest price they are willing to pay, while suppliers set the lowest price they are willing to accept. This process serves as a safeguard for both parties involved.
A call auction is used to describe this type of trading mechanism. While buyers and sellers are effectively paired, it leads to increased liquidity and decreased volatility. A call market is often referred to as an auction.
The term “call” can also refer to a company’s earnings call, during which the company provides updates on its financial performance. Additionally, in the context of bonds, “call” can indicate when a bond issuer redeems or recalls their bonds before their maturity date.
How Does Call Work in Finance?
Call options derive value from underlying assets, such as bonds, stocks, foreign currencies, goods, or other traded resources.
The call owner has the right, but not the obligation, to buy the security that underlies the call at a specific strike price within a defined timeframe.
The individual or entity responsible for selling an option is called the “writer.” The seller must retain the contract and deliver the underlying security if an option is exercised.
In situations where the strike percentage of an option to call is below the industry average at the time of exercise, the holder can acquire the underlying asset at a notably reduced price.
If the market rate falls beneath the strike rate, the call option concludes without meeting its objective and holds no value. A call option may be sold before expiration if it retains value due to market dynamics.
Put options are considered to be the exact opposite of call options. The owner of a put option has the right, but not the obligation, to sell the asset that underlies it at a predetermined price and within a specific timeframe.
Derivatives brokers frequently employ a combination of call and put options to manage and manipulate the risks associated with their positions effectively.
Differences Between Call and Put Options
Another significant type of option is referred to as a put option. Its valuation rises when the price of the underlying stock decreases. Traders can speculate on a stock’s potential decrease in value by purchasing put options. In this context, puts can be considered the inverse of call options despite sharing several similarities regarding risks and rewards.
- Similar to purchasing a call option, purchasing a put option presents the potential for significant returns on your investment.
- Similar to the purchase of a call option, there is a potential risk associated with buying a put option. This risk entails losing the entire investment if the set option expires without value.
- Similar to selling a call option, selling a put option also results in the collection of a premium. However, it is essential to note that the seller assumes all the risks associated with the stock moving in an unfavorable direction.
- In contrast to the sale of a call option, a put option entails a limited potential loss because a stock’s value cannot drop below zero. However, it is essential to note that there is a possibility of incurring losses exceeding the premium received.
Summary
Although all options carry inherent risks, traders can prudently employ various strategies. When options are utilized appropriately, they can effectively mitigate risks and enable individuals to capitalize on a stock’s potential gains or losses. Indeed, options can provide a means if one desires to pursue a high-risk/high-reward strategy.
