Call option
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The document discusses call options. A call option gives the buyer the right, but not the obligation, to buy an underlying asset at a specified price within a specific time period. There are different types of underlying assets for call options, including stocks, indexes, currencies, and commodities. Call options provide leverage for investors and limit their risk to the premium paid, while allowing profits from rising asset prices. However, calls also have disadvantages like time expiration, complexity, and unlimited losses for writers of naked calls. The document provides examples of how call options are exercised based on the direction of the underlying asset price.
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Call option
- 2. Option The right to buy or sell a certain amount of an underlying financial asset at a specified price for a given period of time.
- 3. Types of Options Types of Options Puts Calls Rights Warrants All of the above are types of derivative securities, which derive their value from the price behavior of an underlying real or financial asset.
- 4. Options: Calls Calls may be traded on: Common stocks Stock indexes Exchange traded funds Foreign currencies Debt instruments Commodities and financial futures Owners of put and call options have no voting rights, no privileges of ownership, and no interest or dividend income
- 5. Advantages of Calls Allows use of leverage Leverage: the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return Option buyer’s exposure to risk is limited to fee paid to purchase the put or call option Investor can make money when value of assets go up or down
- 6. Disadvantages of Calls Investor does not receive any interest or dividend income Options expire; the investor has limited time to benefit from options before they become worthless Options are complex and tricky Option seller’s exposure to risk may be unlimited Options are risky because an investor has to be correct on two decisions to make money: Which direction the price of the asset will move When the price change will occur
- 7. How Calls Work Call: a negotiable instrument that gives the holder (buyer) the right to buy the underlying security at a specified price over a set period of time from the seller/maker/writer in exchange for a fee paid to the seller/maker/writer The buyer of the call option wants the price of the underlying assets to go up The seller/maker/writer of the call option wants the price of the underlying assets to go down
- 8. How Calls Work (cont’d) If the price of the underlying assets goes up: The buyer will buy the asset at the lower strike price from the seller/maker/writer and sell it at the higher market price, making a profit The seller will sell the assets at a price lower than the market price. If the seller does not already own the assets, then the seller will have to purchase them at the higher market price Covered call: seller owns the asset Naked call: seller does not own the asset
- 9. How Calls Work (cont’d) If the price of the underlying assets go down: The buyer will let the call option expire worthless and lose the fee paid The seller will keep the fee received and make a profit
- 10. How Calls Work (cont’d) Example: Assume the market price for a share of common stock is $50. A call option to purchase 100 shares of the stock at a strike price of $50 per share may be purchased for $500 If the market price of the stock goes down to $25 per share, the buyer will allow the call option to expire worthless. Loss Loss Cost of call $(500) The buyer’s loss will be: The seller/maker/writer’s profit will be: Profit Profit Fee of call $(500)