What are Call Options?
Call options are investment contracts that give the option buyer the right to buy an underlying asset, like a stock, at a specified price called the strike price within a certain period. These call option contracts typically apply to stocks traded on exchanges, but can also apply to a variety of different investments such as bonds, crypto, commodities, and other currencies.
In order to better understand call options, try thinking of it like an agreement that gives the investor the right to buy or sell some shares at a particular price within a particular amount of time. It is like making a bet that the price will become favorable to the investor within a particular period of time, without actually performing the transaction until the option is exercised, or called.
When the contract time expires, the transaction executes or is voided. Sometimes these options contracts favor the investor, sometimes they favor the company being invested in. This is the risk that is involved in call options. Additionally, the company gets a “premium” or a fee for accepting the options contract that gives the investor more flexibility in making investment choices.
Simplified Example
The share price of “A Corp” today is $3. I have a hunch that A Corp stock price is going to go up, so instead of just outright buying the shares, I enter into a call option contract for 100 shares of A Corp at $3. This contract is valid for 90 days. Within this time period, let’s say the stock price goes up to $4. That is where I set my “strike price.” Now that the price has gone up to $4, I call my option contract and purchase 100 shares of A Corp at the $3 price from when I entered into the contract.
History of the Term Call Option
The exact origin of the term "call option" is uncertain, but it is believed to have emerged in the early days of options trading, which can be traced back to the 17th century. Options contracts, which give the buyer the right but not the obligation to buy or sell an underlying asset at a specified price by a certain date, were initially used in commodity markets to hedge against price fluctuations.
The term "call option" likely emerged to distinguish this type of option from the other common type of option, the "put option." A put option gives the buyer the right but not the obligation to sell an underlying asset at a specified price by a certain date. The terms "call" and "put" are thought to reflect the actions of the option buyer: the call option buyer is "calling" for the right to buy the asset, while the put option buyer is "putting" the asset up for sale.
The term "call option" has become widely used in the financial world and is now understood as a standard term for this type of option contract. It is used in various contexts, including stock options, options on futures contracts, and options on commodities.
Examples
Tech Company Stock Option: Let's say you are bullish on the stock of a technology company, XYZ, and you expect the stock price to increase from its current price of $100 per share. You could purchase a call option on the stock of XYZ, with a strike price of $110 and an expiration date of three months from now. This means that you have the right to buy 100 shares of XYZ at $110 per share at any time before the expiration date. If the stock price of XYZ goes up to $120 per share, you could exercise your call option and buy the shares at the lower strike price of $110 per share, making a profit of $10 per share. Alternatively, you could sell the call option to someone else at a higher price than you paid for it, realizing a profit without ever owning the underlying stock.
Real Estate Option: Suppose you are interested in purchasing a piece of real estate but you are uncertain about its future value. You could purchase a call option on the property with a strike price of $500,000 and an expiration date of six months from now. This gives you the right to purchase the property for $500,000 within the next six months. If the property value rises above $500,000, you could exercise the option and buy the property at the lower strike price, then sell it for a profit. If the property value does not rise above $500,000, you could choose not to exercise the option and let it expire, limiting your losses to the cost of the option.
Commodity Option: Let's say you are a coffee importer and you are concerned about the possibility of rising coffee prices in the future due to supply disruptions or weather events. You could purchase a call option on coffee futures with a strike price of $2.50 per pound and an expiration date of three months from now. This gives you the right to purchase coffee futures at $2.50 per pound, regardless of any increase in market prices. If the market price of coffee goes up to $3.00 per pound, you could exercise the option and buy the coffee futures at the lower strike price of $2.50 per pound, then sell them at the higher market price of $3.00 per pound for a profit. If the market price of coffee does not rise above $2.50 per pound, you could choose not to exercise the option and let it expire, limiting your losses to the cost of the option.