Call option - Wikipedia, the free encyclopedia http://en.wikipedia.

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Call option
From Wikipedia, the free encyclopedia.

A call option is a financial contract between two

parties, the buyer and the seller of this type of option.
Often it is simply labeled a "call". The buyer of the
option has the right but not the obligation to buy an
agreed quantity of a particular commodity or financial
instrument (the underlying instrument) from the seller
of the option at a certain time for a certain price (the
strike price). The seller (or "writer") is obliged to sell
the commodity or financial instrument should the buyer
so decide. The buyer pays a fee (called a premium) for
this right.

The buyer of a call option wants the price of the

commodity/instrument to rise in the future; the seller
eithers expects that it will not, or is willing to give up
some of the upside (profit) from a price rise in return
for (a) the premium (paid immediately) plus (b)
retaining the opportunity to make a gain up to the strike
price (see below for examples).
A graphical interpretation of the payoffs and profits generated by a call
option as seen by the purchaser of the option. A higher stock price
means a higher profit. Eventually, the price of the underlying (i.e.
stock) will be high enough to fully compensate for the price of the
option.

Call options are generally taken into consideration,

while the market is moving up and there is always
chance of getting good returns at fair strike price. So it
is preferred in bullish condition.

The initial transaction in this this context

(buying/selling a call option) is not the supplying of a
physical or financial asset (the underlying instrument).
Rather it is the granting of the right to buy the
underlying asset, in exchange for a fee - the option
price or premium.

Exact specifications may differ depending on option

style. A European call option allows the holder to
exercise the option (i.e., to buy) only on the delivery A graphical interpretation of the payoffs and profits generated by a call
date. An American call option allows exercise at any option as seen by the writer of the option. Profit is maximized when the
option expires worthless (when the strike price exceeds the price of the
time during the life of the option.
underlying), and the writer keeps the premium.
A call option should not be confused with a stock
option. A stock option, the option to buy stock in a particular company, is a right issued by a corporation to a particular
person (typically, employees) to purchase treasury stock. When a stock option is exercised, new shares are issued. When a
call option is exercised, if it involves shares, the shares are simply being transferred from one owner to another. Nor are
stock options traded on the open market.

Call options can be purchased on many financial instruments other than stock in a corporation - options can be purchased
on interest rates, for example (see interest rate cap) - as well as on physical assets such as gold or crude oil.

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Example of a call option on a stock

I buy a call on Microsoft Corporation stock with a strike price of $50 (the future exchange price)
and an exercise date of June 1, 2006. I pay a premium of $5 for this call option. The current
price is $40.
Assume that the share price (the spot price) rises, and is $60 on the strike date. Then I would
exercise my option (i.e., buy the share from the counter-party). I could then sell it in the open
market for $60. My profit would be $10 minus the fee I paid for the option, $5, for a net profit
of $5. I have thus doubled my money (beginning with $5, ending with $10 in my pocket).
If however the share price never rises to $50 (that is, it stays below the strike price) up through
the exercise date, then I would not exercise the option. (If I really wanted to own such a share, I
could buy it in the open market for less than $50, so why exercise the option?) The option would
expire as worthless. I would have lost my entire $5.
Thus, in any future state of the world, my loss is limited to the fee (premium) I initially paid to
purchase the stock, while my potential gain is quite large (consider if the share price rose to
$100).
From the viewpoint of the seller, if the seller thinks the stock is a good one, he/she is $5 better
(in this case) by selling the call option, should the stock in fact rise. However, the strike price (in
this case, $50) limits the seller's profit. In this case, the seller does realize the profit up to the
strike price (that is, the $10 rise in price, from $40 to $50, belongs entirely to the seller of the
call option), but the increase in the stock price thereafter goes entirely to the buyer of the call
option.

From the above, it is clear that a call option has positive monetary value when the underlying instrument has a spot price
(S) above the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a call
option is

Max[(S − K);0] or formally, (S − K) +

where

Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The call price must
reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time
to expiry, and with a more volatile underlying instrument. The science of determining this value is the central tenet of
financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the
buyer and seller must agree on the initial value (the premium), otherwise the exchange (buy/sell) of the option will not
take place.

Related
Moneyness
Option time value
Put option
Put-call parity

See also
Derivatives markets
Derivative security
Financial economics
Futures

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Call option - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Call_option

Financial instruments,Finance

Options
Stock option
Warrants
Foreign exchange option
Interest rate options
Bond options
Options on futures
Swaption
Interest rate cap
Interest rate floor
Exotic interest rate option
Credit default option
binary option
real option

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Categories: Derivatives

This page was last modified 13:03, 30 August 2005.

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