Definition:
Call Options are financial Options contracts that give the call option buyer the right (not the obligation) to buy a financial instrument at a specified pre-determined price with a specified time period.
Key take out " Gives the buyer the right to purchase"
How do Call option work? - Understanding Call option.
Lets assume the buyer is to invest in stock prices. A Buyer does market analysis on stock prices of Company X offered at $100. On the analysis the trader discovers there is potential and has some probability that the stock price of Company X selling at $100 is under valued and may have a potential to increase. The buyer approaches the broker and pay a premium to buy one option contract (100 shares) with expiration of 6 months.
After the premium payment ($300), The broker will allow the trader to open a call option contract (buy rights). Details of this contract will be total number of stock (100) the trader will have bought, strike price ($118)- what the trader anticipates the price will be in the future(days, months or years) and the Expiration period - date with which the buyer of call option will exercise the contract ( Take delivery -"closing trade") - offered by broker in days or months or years.
Once the call option is opened the trader will hold the contract until the exercise time(6 months).
Outcomes of the contract:
There three possible outcomes at the end of the expiration time. They are:
1. In the money
If the share price of Company X at the end of 6 months be $125. Then the buyer will at a state called - In the money. This is because the buyer may exercise the options Call options since it has value in it. To calculate the profit these are the steps:
Outcome = $125
cost per share = $3 ($300/100) - cost of premium / total number of shares bought
strike price = $118
Profit per share = $125 - ($118 + $3)
= $4
Total profit = $4 * 100 * 1 - since the buyer bought one call option
= $400
2. At the money
If the share price of the company after 6 months move to $121. The buyer will be - At the money. No loss or profit were realized.
3. Out of the money
If the share prices were to fall, say $80, the option will not be exercised. Since its a right to buy and not the obligation, the buyer will not invest in the current new price shares. Ordinarily, from other finance instruments losses corresponding to the said amount will be calculated and deducted to the buyer's account. This may have a big loss impact to the buyer's portfolio.
However, in the case of Call options only the premium amount will be lost, in our case $300.
Types of Call options:
There are two types of call options. These are:
1. Long call options - Price rises
As the name suggests its a buying call option - "Going long"
The buyer of a call option buys a call option and hopes the prices of finance instrument will rise past the strike price before the end of expiration time or date. In this case, for profits to be realized the prices of the instrument must rise past the strike price plus premium cost per share.
the above calculations would be used.
2. Short Call options - price falls
As the name suggest its a selling call option - "Going short"
The seller of a call options sells call option with prediction that the prices will fall past the strike price before the end of the expiry period
In the case of short call options two factor will determine the results at the end of the expriry time. These are:
a. Is the Call Option Covered?
For covered call options, the seller of the call option also owns the underlying stock.
This limits the amount of losses one can incur.
b. Is the Call Option Naked?
For the naked call options, the seller of the call options does not own the said stock.
This call option is considered risky as it may increase levels of losses to unpredictable levels.
Uses of call Options / Advantages of Call options
1. To generate income stream
People engaging and employing right trading measures tend to use call options as a source of income.
2. To speculate
The buyer of the call option is enabled to hold a call option with speculation or hopes the call options will gain high prices in the near future, while risking only small amounts compared to actual finance instrument market prices.
3. To Manage taxes
Since in most jurisdictions buying company shares directly attracts more taxes, when call option method is implemented only income generated from profits are taxable. This enables one to manage levels of taxes.
4. For Hedging
Just like insuring your business against losses, institutions may use hedging to guard their share prices from high losses in the unforeseen future.
Disadvantages of Call options.
1. Can be risky.
Just like any other trades, trading on Call options has the risk of loosing high amount of money in the portfolio.
2. Not for every person.
To open a call option account, the buyer has to approved by the broker to hold one. This is because of the requirement and hurdles for one to qualify to be call option trader.
3. Time consuming.
To analyze the market to come up with the right data to invest in call option is time consuming. This is from amount of information to be gathered and analysis to be done to come up with the right signal.
4. May result in short-term gains with high fees.
Since most trades are based on days or months, this will enable the trader to have quick short term gains. This will have a ripple effect of attracting many fees and commissions to open and run this trades. Also depending on the jurisdictions the trade taking place there may be taxes associated with each trade.
By use of Call option in the right way one may tend to increase or boost portfolio size, also negative use of call options could have devastating and ripple losses to a portfolio size.
Related on this
Social Plugin