Call option definition
/What is a Call Option?
A call option is a financial arrangement under which an investor has the right, but not the obligation, to buy an asset at a predetermined price within a specific range of dates. An investor only exercises a call option when doing so will result in the acquisition of an asset at a price below its current market price, so that the investor can then sell the asset for a profit.
Call options are routinely used to speculate on price changes. If the price of the underlying asset increases, then the option holder earns a profit. However, if the price of the asset declines, then the option holder chooses not to exercise the option, and instead absorbs the cost of the option contract.
In all cases, the seller of a call option takes on the obligation to sell the targeted asset at the price specified in the option contract, if the holder of the option chooses to exercise it.
Advantages of Call Options
There are several advantages to entering into a call option arrangement, which are as follows:
Profit opportunity. The holder of a call option can earn a substantial profit if the price of the underlying asset increases substantially.
Modest cash commitment. The holder of a call option may be able to acquire it for a small amount, so there can be a major return on investment if the underlying asset turns out to have increased in value substantially.
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Call Options vs. Put Options
The opposite of a call option is a put option, which gives its holder the right, but not the obligation, to sell an asset at a predetermined price within a specific range of dates. Thus, a call option involves the purchase of an asset, while a put option involves the sale of an asset.
Example of a Call Option
An employee is given a call option to buy 1,000 shares of her employer's stock at a price of $15 per share within the next two years. In the following year, the market price of the stock increases to $18, so she exercises the call option, buying all 1,000 shares for a total of $15,000. She then sells the shares on the open market for $18,000, pocketing a profit of $3,000.