What Is a Call Option?

Call options grant buyers the right to purchase an underlying asset at a future date and specified price, providing limited risk and unlimited upside potential.

Dec 17, 2024 at 10:11 pm

What Is a Call Option?

Call options are derivative contracts that give the buyer the right, but not the obligation, to buy an underlying asset at a specified price (strike price) on or before a certain date (expiration date). They are commonly used to speculate on the future price of the underlying asset, hedge against risk, or generate income.

Key Points:

• Call options are bullish contracts, meaning they benefit from increases in the underlying asset's price.
• They provide limited downside risk and unlimited upside potential.
• The profit or loss on a call option depends on the difference between the underlying asset's price and the strike price.

How Call Options Work

1. Purchase: The buyer purchases a call option contract with a specific underlying asset, strike price, and expiration date.
2. Underlying Asset Price Increase: If the price of the underlying asset rises above the strike price before the expiration date, the option becomes "in-the-money."
3. Exercising the Option: The buyer can exercise the option to buy the underlying asset at the strike price, regardless of the current market price.
4. Expiration: If the option is not exercised before the expiration date, it expires worthless, and the buyer loses the premium paid.

Advantages of Call Options

• Potential Profit: Call options offer unlimited upside potential if the underlying asset price rises significantly.
• Limited Risk: The maximum possible loss is limited to the premium paid for the option.
• Hedging: Call options can be used to hedge against potential losses in the underlying asset.
• Income Generation: Selling covered calls can generate income if the asset price remains stable or declines.

Disadvantages of Call Options

• Time Decay: The value of a call option decreases as the expiration date approaches, even if the underlying asset's price remains unchanged.
• Volatility Risk: Call options are sensitive to changes in volatility of the underlying asset.
• Exercise Date Risk: If the underlying asset price rises significantly after the expiration date, the buyer may miss out on potential profits.

FAQs

What happens if the underlying asset price falls below the strike price?

The call option will expire worthless, and the buyer will lose the premium paid.

Can call options be used for short selling?

No, call options are bullish contracts and cannot be used for short selling.

How is the premium for a call option determined?

The premium depends on factors such as the underlying asset's price, strike price, expiration date, and volatility.

What is the difference between a call option and a put option?

A call option gives the buyer the right to buy an asset, while a put option gives the buyer the right to sell an asset.

Can call options be exercised early?

Yes, call options can be exercised at any time before the expiration date, but it is usually not optimal to do so.