A call option is a type of financial instrument known as a derivative. It is basically an agreement between two parties to exchange ownership of a stock at an agreed upon price within a certain time period. The exchange of the stock is optional and the owner of the option decides whether it takes place.
The agreed upon price of the exchange is called the strike price. The date on which the agreement expires is the expiry date of the call option. The amount of money required to purchase this option is called the premium. If the exchange takes place, then one is said to have exercised the call option.
Premiums for this kind of derivative are always quoted per stock, but sold in lots of 100 shares minimum. Call options are always an agreement about being able to purchase the stock at the agreed upon price. They come in both European style and American style. The main difference between these two is that European options can only be exercised on the expiry day, while American style options can be exercised at any time during their life.
Call options are frequently described by the relationship of the strike price to the stock price. One for which the strike price is equal to the stock price is said to be at the money. If the strike price is above the stock price, the option is said to be out of the money. Finally, if the strike price is less than the stock price, the option is said to be in the money.
There are two investment styles when investing in these derivatives. Conservative investors sell an out of the money call option on a stock that is part of their portfolio to increase the overall return on their portfolio. The intention is that the stock price will not increase at such a rate that it becomes equal to or greater than the strike price. In this case, the investor gets to keep the premium and the stock, and the option expires worthless. The process will then be repeated.
The speculative investor will purchase at the money call options without owning the underlying stock. The expectation is that the price of the option will increase as the price of the stock increases. Typically, if the stock price increases by one US dollar (USD), the price of the option will also increase by one USD. However, since the call option may cost as little as one tenth of the stock, the rate of return on the investment is much higher than it would be if the stock were purchased.
For example, if the stock cost $10 USD, then the call option for this stock for a 10 USD strike price could cost 1 USD. If the stock were to increase in price to 11 USD, the profit with the stock purchase is 1 USD and equal to a 10% return; however, the call option profit is also $1 USD, and since only 1 USD was invested, a 100% return is realized. However, if the price were to drop to 9.50 USD, the option would become worthless and the entire $1 USD investment would be lost, while only $0.50 USD would be lost with the stock purchase. With the leverage, this type of derivative provides that gains are magnified, but losses are as well. The stock owner would also receive any dividends paid out, while the owner of a call option would not.
