Call Options: Learn the Basics of Buying and Selling
Options are an important form of derivatives, common in the financial world, offering investors the opportunity to buy or sell an asset at a future predetermined price. Call options are a common option type which give the holder the right, but not the obligation to purchase an underlying asset, such as stocks, at a specific price, within a limited period of time. Understanding how call options work and their associated risks is essential for any financial investor.
What are Call Options?
A call option gives the buyer the right, but not the obligation, to buy an underlying asset for a predetermined price before a set expiration date. Call options are also known as “bets” to buy the asset, since the buyer pays a premium for the right to make the purchase. The writer of the call option has to sell the asset to the buyer if it is exercised. The buyer of the call option has the ability to benefit from the asset while not taking on any additional risk.
Using Call Options
Call options have several functions when it comes to diversifying or increasing a portfolio’s return. They can be used to generate income or as a risk-mitigating strategy.
A long call option strategy is used when a trader is expecting a rise in the price of the underlying asset. By buying the call option, the buyer has the potential to receive a profit of the difference between the strike price of the option sold and current asset price.
Call options are also used in hedging strategies, as a way of reducing risk and protecting a portfolio. If a trader owns a stock, for example, and believes the stock may decline before the expiration of the option, he may enter into a short call option transaction. This way, he has contracted to sell the stock at the strike price and will not take on any extra losses in case the price drops.
Pricing and Buying Call Options
Call options are priced with several key components; intrinsic value, time value and volatility. Intrinsic value is inherent to an asset’s stock price and is simply the difference between the strike price of the option and the underlying asset’s current price. Time value is the additional amount allocated to an option’s price and depends on the amount of time remaining on the option until its expiration date. Volatility is used to measure price action and expected volatility of a stock price and affects time value the most.
When a trader is looking to buy a call option, they must identify a strike price that they are happy with and are willing to pay the premium for that right. It is important to note that if the trader’s prediction is wrong, they will lose the premium that they paid.
Risks of Call Options
The potential risks associated with profit from call options are limited to the premium the investor has paid for the option and the amount of the asset required to cover taxes, commissions and other fees. The buyer of the call option is at risk of their prediction turning out to be wrong; in this situation, the premiums will stay with the option seller and the buyer will lose the money that he paid for the option.
In addition, since call options are subject to different market conditions, such as event risk, it is important to continuously monitor the asset and its status in order to be aware of any risks that may arise.
Call options offer a unique form of derivative investing and the opportunity to increase returns and reduce risks. Understanding how they work, what they are used for and the potential risks associated with them is essential for any investor looking to incorporate call options into their financial strategy. With the right knowledge and understanding, call options can be a profitable option for any investor.
