A call option is a derivative contract that gives the holder the right, but not the obligation, to buy an underlying security at a specified price on or before a specified date.
What is a Call Option
There are a wide variety of uses for the purchase and sale of call options in contemporary trading. However, at its simplest a call option is merely a bet on an increase in the price of a stock that does not require the actual purchase of that stock.
They are considered a riskier form of speculating on an increase in the price of a stock, as the entire value of the premium can be lost if the price of the underlying stock fails to exceed a certain point.
However, the potential returns from an increase in the price of the underlying stock are similarly out-sized compared to traditional stock buying due to the leverage involved with options.
When you are a buyer of a call you are speculating that the price of the underlying will increase in value before the expiration date on the contract. While if you are a seller of a call option then you want the price of the underlying to at or below your strike price, which is a neutral to bearish position.
Breakdown
Imagine that an investor wants to sell a call contract for 1 share of company A for $2 per share that expires in one week.
• The seller of the call is known as the ‘underwriter‘ for that contract, while the buyer of the call is known as the ‘holder’ of that contract.
• The price that the seller of the call option receives and the buyer of the call pays is known as the contract’s ‘premium’.
• The one week duration of the call is known as the ‘expiry date‘ of the contract.
• American style call options allow the contract holder to exercise the contract on or before the expiry date, while European style call options can only be exercised on the expiry date.
• Call options can be resold on the open market by the holder, though the underwriter remains the same.
• Call options for sale are displayed in an ‘options chain’, which is a table detailing the various call options available according to their expiry date and strike price, and displays the current bid/ask spread for the premium or sale price of the contract.
Final Thoughts
There are a large number of reasons that investors may want to buy or sell calls on a stock or some other underlying asset or security.
They also often play a complementary role in larger and more complex positions, as their wide variability in terms of expiry dates and strike prices allows investors to create highly sophisticated trading positions using call options, the underlying stock or security, and other derivatives.