What is a Call Option?

//What is a Call Option?
What is a Call Option? 2017-10-01T06:04:36+00:00

Definition: A call option is a contract that gives the option holder the right to purchase securities at a specified price on or before the option’s maturity date. These securities could include stocks, bonds, or other commodities.

What Does Call Option Mean?

What is the definition of call option? Basically, it’s a contingent purchase agreement between someone who owns a security and someone who wants to purchase it. The current owner of the securities is paid a premium and agrees to allow the prospective owner to purchase the securities at specific price, called the strike price, before a specific date, the contract maturity date. Although a call-option gives the option owner the right to purchase the securities, he is not obligated to exercise his call on or before the contract matures. He simply has the right, or option, to purchase the asset from the owner.

On the other hand, the option seller is obliged to sell the securities on or before maturity if the option holder chooses to exercise his right. Call options are exercised at the strike price, and investors realize a profit if the strike price is higher than the market price of the underlying security. The maximum loss for a call-option is the premium paid for the option.

Let’s look at an example.

Example

George owns 100 shares of a technology company that trade at $87. George believes that the stock price will rise to $102 within the next 5 months, and he decides to buy a call option on the technology stock for $3 at a strike price of $100. He pays $300 for 100 shares (each option contract covers 100 shares).

How can George profit from the option?

If the stock price rises at $110, George will exercise his option, and he will buy 100 shares for $100 to sell them for $110 on the open market. Therefore, George will realize a profit of ($110 – $100) x 100 shares = $1,000 minus the premium of $300 that George paid for the option his net profit is $1,000 – $300 = $700.

If the stock price drops to $75, George is not obligated to exercise his option. Instead, his total loss will be the premium of $300 that he paid to acquire the option.

Summary Definition

Define Call Option: A call option is an investment agreement that gives the option owner the right to purchase securities at a stated price on or before a specific date.