On Call Options

(From Wikipedia, accessed Feb 24th)

A call option is a financial contract between two parties, the buyer and the seller of this type of option. Often it is simply labeled a "call". The buyer of the option has the right but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.

The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller eithers expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for (a) the premium (paid immediately) plus (b) retaining the opportunity to make a gain up to the strike price (see below for examples).

Call options are most profitable for the buyer when the underlying instrument is moving up, making the price of the underlying instrument closer to the strike price. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money".

The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.

Exact specifications may differ depending on option style. A European call option allows the holder to exercise the option (i.e., to buy) only on the delivery date. An American call option allows exercise at any time during the life of the option.

Call options can be purchased on many financial instruments other than stock in a corporation - options can be purchased on interest rates, for example (see interest rate cap) - as well as on physical assets such as gold or crude oil. A call option should not be confused with a stock option (or with a warrant). A stock option, the option to buy stock in a particular company, is a right issued by a corporation to a particular person (typically, employees) to purchase treasury stock. When a stock option is exercised, new shares are issued. When a call option is exercised, if it involves shares, the shares are simply being transferred from one owner to another. Nor are stock options traded on the open market.

An Example

• An investor buys a call on Microsoft Corporation stock with a strike price of $50 (the future exchange price) and an exercise date of June 1, 2006, and pays a premium of $5 for this call option. The current price is $40.
• Assume that the share price (the spot price) rises, and is $60 on the strike date. The investor would exercise the option (i.e., buy the share from the counter-party), and could then hold the share, or sell it in the open market for $60. The profit would be $10 minus the fee paid for the option, $5, for a net profit of $5. The investor has thus doubled his money, having paid $5, and ending up with $10.
• If however the share price never rises to $50 (that is, it stays below the strike price) up through the exercise date, then the option would expire as worthless. The investor loses the premium of $5.
• Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited (consider if the share price rose to $100).
• From the viewpoint of the seller, if the seller thinks the stock is a good one, he/she is $5 better (in this case) by selling the call option, should the stock in fact rise. However, the strike price (in this case, $50) limits the seller's profit. In this case, the seller does realize the profit up to the strike price (that is, the $10 rise in price, from $40 to $50, belongs entirely to the seller of the call option), but the increase in the stock price thereafter goes entirely to the buyer of the call option.