Updated July 7, 2023
Definition of Call Option
A call option is defined as the derivative contract between the two parties, i.e., the buyer of the option and the seller of the option, and which gives the right but not the obligation to the buyer of the call options to exercise the call option and to purchase the asset from the seller of a call option for the stipulated period at stipulated conditions, i.e., the right of exercise.
Explanation
Every derivative has two options: the call option and the put option. It is the one that gives the right but not the obligation to the buyer of the call option to buy the call option. The buyer of a call option can exercise his right even before expiration. When the buyer exercises his right of purchase even before the expiration date, the seller of the option has no option available to him other than selling the call options to the buyer at the strike price. The buyer buys the call option expecting to increase the price and earn capital profits. Even a small move in the market allows for increasing profit for the traders. Hence, it is considered to be the favorite among traders.
There are two types of it: The long and the short call options.
- A long call option considers the underlying asset’s market price to increase the strike price before the expiration.
- The short call option is when the underlying asset’s price is predetermined, and the investor has to buy that asset at that predetermined price.
If the security price rises before the exercise date, the investor can earn a profit by buying it. In such a case, the securities should be purchased at the strike price and immediately sold off at the higher market price. However, if the price does not rise, the investor will suffer the loss of the premium amount paid.
The profit to the option holder is calculated by subtracting all the transactional fees and the premium already paid. The net remainder will be the profit for the investor. If the investor understands the capital market well and anticipates that the security price will rise shortly, he can earn a profit; otherwise, he has to bear the loss in the form of a premium already by the investor.
Examples of Call Options (With Excel Template)
Let’s take an example to better understand the Call Option calculation in a better manner.
Example #1
For example, stock options are the options for the 200 shares of an underlying stock of XYZ Ltd. The buyer, Paul, buys one call options contract on the XYZ stock having a strike price of $50. For the contract, Paul pays $250. At the option contract’s expiration date, the shares of XYZ Ltd are selling for $ 70. The option contract gives the right to the buyer to purchase shares of the company at the strike price. Since, in the present case, the shares are currently trading at a price above the exercise price, the option holder will exercise his right to purchase the shares at the exercise price. In this case, the profit of the buyer, if the option is exercised, is as below-
| When prices go beyond exercise price | ||
| A | Number of shares in the contract | 200 |
| B | Exercise price | $ 50.00 |
| C | Purchase price (A*B) | $ 10,000.00 |
| D | Premium amount | $ 250.00 |
| E | Market price | $ 70.00 |
| F | Selling price | $ 14,000.00 |
| G | Total profit excluding premium (F-C) | $ 4,000.00 |
| H | Total profit considering premium paid (G-D) | $ 3,750.00 |
Example #2
Let’s take the example of the company ABC Ltd. The details are as follows:
The price of each share of ABC Ltd is $100. Peter holds 100 shares in ABC Ltd. Next month, the maximum increase in the share of ABC Ltd will be $ 150 per share. Peter studies call option and expect that call trading of $150 exists.
Peter sold one call option for which he received $3 per share as the premium. What will be the consequences in case prices go beyond $150, and if prices do not go beyond $150
| When prices go beyond $150 | |
| Price per share of ABC Ltd | $ 100.00 |
| No. of shares Peter holds | 100.00 |
| Here, Peter will earn the premium if he sells the shares. | |
| Premium per share | $ 3.00 |
| Premium amount | $ 300.00 |
| Exercise price | $ 150.00 |
| Amount of profit on the sale of shares (per share) | $ 50.00 |
| Total profit excluding premium | $ 5,000.00 |
| Total profit, including premium | $ 5,300.00 |
| When prices do not go beyond $150 | |
| Price per share of ABC Ltd | $ 100.00 |
| No. of shares Peter holds | 100.00 |
| Here, Peter will earn the premium if he sells the option. | |
| Premium per share | $ 3.00 |
| Premium amount | $ 300.00 |
| Exercise price | $ 150.00 |
| If the price does not go beyond $150, Peter has to hold the shares and cannot sell them share in the market. | |
| Total profit will be equal to the premium amount | $ 300.00 |
Conclusion
In the call option, the buyer earns a profit when the price of the option he purchased at the strike price rises. When the stock rises, its value also gets increases. It is considered the best option for earning a profit because the buyer here can lock the option’s price at the specified time. Even with a small move in the market, the opportunity to profit from call options increases. Hence, it is considered to be the favorite among traders. However, dealing with it requires sound knowledge and anticipation of the capital market.
Recommended Articles
This is a guide to Call Options. Here we discuss how to calculate call options along with practical examples. We also provide a downloadable Excel template. You may also look at the following articles to learn more –
