Call Option is a Financial Instrument that gives the holder the right, but not the obligation, to purchase an underlying asset at a predetermined price, known as the strike price, within a SPECIFIC period of time, known as the ‘expiration date’.
They are commonly USED in the stock market as a means of speculating on the future price of a stock, but they can also be used to hedge against potential losses.
Table of Contents
1. Practical Example (Trading)
To better UNDERSTAND how a Call Option works, let’s consider an example.
Suppose you believe that a stock, XYZ, currently trading at $50 per share, is going to increase in price over the next few weeks. You could PURCHASE a call option for XYZ, with a strike price of $55 and an expiration date of three weeks from now, for a premium of $2 per share.
If the price of XYZ increases to $60 per share within the three-week period, you can EXERCISE the Call Option and purchase the shares at the strike price of $55. Since the shares are currently trading at $60, you can immediately sell them for a profit of $5 per share.
Your NET PROFIT, after accounting for the premium paid for the call-option, would be $3 per share.
However, if the price of XYZ DOES NOT increase, and instead decreases to $45 per share, the Call Option would expire worthless, and you would lose the premium paid for the option.
In this Scenario, it would have been more PROFITABLE to simply purchase the shares outright at the current market price of $50.
2. Practical Use (Speculation and Hedge)
Call-Options are often used by Traders and Investors to speculate on the future price of a stock or to hedge against potential losses.
For example, an investor who owns a large amount of a particular stock may purchase a Call-Option on that stock as a form of INSURANCE against a potential decline in the stock’s price. If the price of the stock FALLS, the investor can exercise the call option and sell the shares at the strike price, thereby limiting their losses.
In addition to stocks, Call-Options can be used to purchase other underlying assets, such as commodities, currencies, and even real estate. However, the use of Call-Options is NOT without risk. The value of a call option can be AFFECTED by a number of factors, including the price of the underlying asset, the strike price, the time remaining until expiration, and the volatility of the underlying asset.
It is important for Traders and Investors to CAREFULLY consider these factors before purchasing a call option.
Call-Options can also be used in combination with other financial instruments, such as put options, to create more COMPLEX ‘trading strategies‘.
For example, a trader may purchase BOTH a [Call Option] and a [Put Option] on the same stock, with the same Expiration Date and Strike Price. This is known as a “Straddle” Strategy, which can be used to profit from a significant move in EITHER direction of the stock’s price.
The Bottom Line
Call Option is a POWERFUL ‘financial instrument’ that can be used to speculate on the future price of an underlying asset or to hedge against potential losses.
However, Call-Options are NOT without risk, and it is important for Traders and Investors to carefully consider the various factors that can affect the value of a Call-Option before making any investment decisions. With careful analysis and a sound trading strategy, Call Options can be a valuable tool for traders and investors looking to profit from the stock market.
Chartered Accountant (Institute of Chartered Accountants of Pakistan)
Bachelor of Accounting Honours (Asia e University, Malaysia)