Call option

Definition

A call option is a financial contract that gives the holder the right, but not the obligation, to buy a specific amount of an underlying asset at a predetermined price, known as the strike price, within a specified time period. This financial instrument is commonly used in options trading strategies to leverage potential gains from an increase in the asset's price while limiting risk to the premium paid for the option.

5 Must Know Facts For Your Next Test

1. Call options can be used to hedge against potential increases in asset prices, allowing investors to secure a purchase price ahead of time.
2. The value of a call option increases as the underlying asset's price rises above the strike price, making it profitable for the holder.
3. Call options have expiration dates, meaning they must be exercised or sold before this date, or they will become worthless.
4. Investors can sell call options they own if they believe the underlying asset will not reach the strike price before expiration, allowing them to keep the premium received.
5. The intrinsic value of a call option is determined by how much the current market price of the underlying asset exceeds the strike price.

Review Questions

• How do call options work in relation to underlying assets and their prices?
  • Call options provide investors with the right to buy an underlying asset at a predetermined strike price within a specific time frame. If the market price of the asset rises above the strike price, the call option becomes valuable since it allows the investor to purchase at a lower price. This mechanism allows investors to potentially profit from rising markets while limiting their risk to just the premium paid for the option.
• What are some strategies that traders might use when trading call options?
  • Traders can employ various strategies when trading call options, including buying calls for direct exposure to upward price movements, writing covered calls to generate income from premiums while holding an underlying stock, or using spreads to manage risk. Each strategy can be tailored based on market outlook and risk tolerance. Understanding how these strategies interact with market conditions is essential for effective options trading.
• Evaluate how changes in market conditions can affect the pricing and profitability of call options.
  • Market conditions such as volatility, interest rates, and time until expiration significantly impact call option pricing. For example, higher volatility typically increases an option's premium since it raises the potential for substantial price movements in favor of the option holder. Additionally, as expiration approaches, time decay can erode an option's value if it remains out of the money. Therefore, assessing these factors allows traders to make informed decisions about buying or selling call options effectively.

Related terms

put option: A put option is a financial contract that gives the holder the right, but not the obligation, to sell a specific amount 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 purchase the underlying asset.

premium: The premium is the cost of purchasing an option, representing the price paid by the buyer to the seller for the rights granted by the option.