Definition of Call Option
A call option is a type of options contract that gives the buyer the right, but not the obligation, to buy a specific quantity of an underlying asset at a predetermined price (known as the strike price) within a specified time frame. Investors purchase call options when they anticipate that the price of the underlying asset will increase. The seller of the call option, also known as the writer, is obliged to sell the asset if the buyer decides to exercise the option.
Examples
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Stock Call Option: An investor buys a call option for Company XYZ’s stock with a strike price of $50, expiring in three months. If the stock price rises to $60 before expiration, the investor can buy the stock at $50 and potentially sell it at $60, making a profit.
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Real Estate Call Option: A speculative real estate investor enters into a call option to purchase a plot of land for $200,000 within the next year. If the area’s land values increase and the land is now worth $250,000, the investor can exercise the option, buy it at $200,000, and sell it at the market value.
Frequently Asked Questions
1. What is the difference between a call option and a put option?
- A call option gives the owner the right to buy an asset at a specific price within a certain time frame, while a put option gives the owner the right to sell an asset under the same conditions.
2. Why would an investor buy a call option?
- An investor might buy a call option to speculate on the price increase of an asset or to hedge against potential price increases for assets they need to purchase in the future.
3. What happens when a call option expires?
- If a call option is not exercised by its expiration date, it becomes worthless, and the option buyer loses the premium paid. If exercised, the buyer can purchase the asset at the strike price.
4. Can a call option be sold before it expires?
- Yes, a call option can be sold before expiration in the options market, allowing the owner to capture any potential profit if the market price of the option has increased.
5. Are call options more affordable than buying stocks outright?
- Yes, call options typically require a smaller upfront investment (the premium) compared to buying the underlying stock outright, allowing investors to control a large number of shares with less capital.
Related Terms
- Strike Price: The fixed price at which the owner of a call option can purchase the underlying asset.
- Premium: The amount paid by the buyer to the seller for the call option.
- Expiration Date: The date on which the call option expires and can no longer be exercised.
- In-the-Money: When the current price of the underlying asset is above the strike price of the call option.
- Out-of-the-Money: When the current price of the underlying asset is below the strike price of the call option.
- Option Writer: The seller of the call option who has the obligation to sell the underlying asset if the option is exercised.
Online Resources
References
- Hull, John C. “Options, Futures, and Other Derivatives.” Pearson Education, 10th Edition, 2017.
- McMillan, Lawrence G. “Options as a Strategic Investment.” New York Institute of Finance, 5th Edition, 2012.
- Natenberg, Sheldon. “Option Volatility and Pricing: Advanced Trading Strategies and Techniques.” McGraw-Hill Education, 2nd Edition, 1994.
Suggested Books for Further Studies
- “Options Trading for Dummies” by Joe Duarte
- “Trading Options Greeks: How Time, Volatility, and Other Pricing Factors Drive Profit” by Dan Passarelli
- “Option Volatility and Pricing: Advanced Trading Strategies and Techniques” by Sheldon Natenberg
- “Options as a Strategic Investment” by Lawrence G. McMillan
Real Estate Basics: Call Option Fundamentals Quiz
### What does a call option provide for its buyer?
- [ ] The obligation to buy an asset at a set price.
- [x] The right to buy an asset at a set price.
- [ ] The right to sell an asset at a future date.
- [ ] The obligation to sell an asset.
> **Explanation:** A call option provides the buyer with the right, not the obligation, to buy the underlying asset at a predetermined price within a specific period.
### What is primarily paid by the buyer to the seller of a call option?
- [ ] Dividend
- [x] Premium
- [ ] Interest
- [ ] Mortgage
> **Explanation:** The buyer of a call option pays a premium to the seller. This is the price paid for acquiring the right to purchase the underlying asset.
### What term describes a situation where the current price of the underlying asset is above the strike price of the call option?
- [ ] Out-of-the-Money
- [x] In-the-Money
- [ ] Above Water
- [ ] Premium Price
> **Explanation:** When the current price of the underlying asset is above the strike price of a call option, the option is considered "In-the-Money."
### Who has the obligation to sell the underlying asset if the call option is exercised?
- [ ] The stock market
- [ ] The broker
- [x] The option writer
- [ ] The option buyer
> **Explanation:** The option writer, or the seller of the call option, is obligated to sell the underlying asset if the option buyer decides to exercise the option.
### What is the purpose of buying a call option for speculative reasons?
- [x] To profit from potential increase in asset's price
- [ ] To lock in a future purchase price for personal use
- [ ] To ensure future taxes are minimized
- [ ] To establish long-term ownership of the asset
> **Explanation:** Investors buy call options for speculative reasons to profit from a potential increase in the price of the underlying asset.
### What happens to an unexercised call option at expiration?
- [ ] It turns into shares of the underlying asset
- [x] It becomes worthless
- [ ] It renews automatically
- [ ] It transfers to another owner
> **Explanation:** An unexercised call option becomes completely worthless upon expiration, resulting in a total loss of the premium paid by the buyer.
### What type of underlying asset can a call option apply to?
- [ ] Only stocks
- [ ] Only real estate
- [x] Various assets including stocks, real estate, and commodities
- [ ] Only government bonds
> **Explanation:** Call options can apply to a variety of underlying assets, including stocks, real estate, commodities, and more.
### What financial benefit do options provide for investors with limited capital?
- [ ] Guaranteed returns
- [ ] Eliminates risk entirely
- [x] Leverage to control more assets with less capital
- [ ] Fixed income
> **Explanation:** Options provide leverage, allowing investors to control larger quantities of an asset with less capital compared to buying the asset outright.
### When are call options particularly useful for hedging?
- [x] When an investor wants to protect against increases in an asset's price
- [ ] When an investor wants to ensure a fixed dividend income
- [ ] When the underlying asset is expected to decrease in price
- [ ] When the aim is to freeze the market
> **Explanation:** Call options are useful for hedging when an investor seeks to protect against potential increases in the price of an underlying asset.
### A call option's intrinsic value is the difference between what two prices?
- [ ] Purchase price and current interest rates
- [ ] Dividend yield and premium paid
- [x] Current asset price and strike price
- [ ] Current asset price and option writer's cost
> **Explanation:** A call option's intrinsic value is the difference between the current market price of the underlying asset and the strike price of the option.
