Call option

Definition

A call option is a financial derivative that gives the holder the right, but not the obligation, to buy a specified quantity of an underlying asset at a predetermined price (known as the strike price) within a specified time period. This type of option is often used by investors who expect the price of the underlying asset to rise, allowing them to purchase it at a lower price before the option expires.

5 Must Know Facts For Your Next Test

1. Call options can be traded on various underlying assets, including stocks, indices, and commodities.
2. The premium is the price paid by the buyer to purchase a call option, and it represents the maximum loss for the buyer if they choose not to exercise the option.
3. If the market price of the underlying asset exceeds the strike price at expiration, the call option is considered 'in the money,' allowing for potential profit when exercised.
4. Investors may use call options for hedging purposes or to speculate on price movements, providing leverage with relatively low capital outlay.
5. The intrinsic value of a call option is determined by the difference between the current market price of the underlying asset and its strike price when it is in-the-money.

Review Questions

• How does a call option differ from a put option in terms of investor strategies and market outlook?
  • A call option differs from a put option in that it provides the holder with the right to buy an asset, while a put option gives the right to sell an asset. Investors who purchase call options typically expect that the price of the underlying asset will rise, allowing them to buy at a lower strike price. In contrast, those who buy put options expect prices to fall and seek to profit from selling at a higher price before expiration. Both strategies reflect different market outlooks—bullish for call options and bearish for put options.
• Discuss how factors like market volatility and time until expiration impact the pricing of call options.
  • Market volatility significantly impacts the pricing of call options because higher volatility increases the potential for greater price swings in the underlying asset. As volatility rises, so does the probability that a call option will end up in-the-money by expiration, leading to higher premiums. Additionally, time until expiration affects pricing; longer durations give more opportunity for favorable price movements, which also results in higher premiums. As expiration approaches, if other factors remain constant, premiums tend to decrease due to time decay.
• Evaluate how understanding call options can enhance an investor's overall trading strategy and risk management approach.
  • Understanding call options allows investors to enhance their trading strategies by providing opportunities for both speculation and hedging. By using call options, investors can gain leveraged exposure to potential upward movements in an asset’s price without needing significant capital. Additionally, they can employ call options as part of risk management tactics, such as protecting existing positions against potential declines or ensuring gains on stocks they own. This knowledge empowers investors to navigate market fluctuations more effectively while managing their risk exposure.

Related terms

put option: A put option is a financial derivative that gives the holder the right, but not the obligation, to sell a specified quantity of an underlying asset at a predetermined price within a specified time period.

strike price: The strike price is the predetermined price at which the holder of a call option can buy the underlying asset when exercising the option.

expiration date: The expiration date is the last date on which the holder of a call option can exercise their right to purchase the underlying asset.