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Investment banks and other institutions use call options as hedging instruments. Due to the high degree of leverage, call options are considered high-risk investments. They are a leveraged investment that offers potentially unlimited profits and limited losses (the price paid for the option). SpeculationĬall options allow their holders to potentially gain profits from a price rise in an underlying stock while paying only a fraction of the cost of buying actual stock shares. Investors use call options for the following purposes: 1.
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If the price of the underlying security remains relatively unchanged or declines, then the value of the option will decline as it nears its expiration date. The buyer can also sell the options contract to another option buyer at any time before the expiration date, at the prevailing market price of the contract. For example, if a buyer purchases the call option of ABC at a strike price of $100 and with an expiration date of December 31, they will have the right to buy 100 shares of the company any time before or on December 31. Since call options are derivative instruments, their prices are derived from the price of an underlying security, such as a stock. Small investors use options to try to turn small amounts of money into big profits, while corporate and institutional investors use options to increase their marginal revenues and hedge their stock portfolios. In this example, if you had paid $200 for the call option, then your net profit would be $800 (100 shares x $10 per share – $200 = $800).īuying call options enables investors to invest a small amount of capital to potentially profit from a price rise in the underlying security, or to hedge away from positional risks. Your net profit would be 100 shares, times $10 a share, minus whatever purchase price you paid for the option. Then you could exercise your right to buy 100 shares of the stock at $30, immediately giving you a $10 per share profit. Before your option expires, the price of the stock rises from $28 to $40. Alternatively, if the price of the underlying security rises above the option strike price, the buyer can profitably exercise the option.įor example, assume you bought an option on 100 shares of a stock, with an option strike price of $30. If the price of the underlying security does not increase beyond the strike price prior to expiration, then it will not be profitable for the option buyer to exercise the option, and the option will expire worthless or “out-of-the-money.” The buyer will suffer a loss equal to the price paid for the call option. On the other hand, the seller of the call option hopes that the price of the asset will decline, or at least never rise as high as the option strike/exercise price before it expires, in which case the money received for selling the option will be pure profit. Usually, options are sold in lots of 100 shares. The buyer of a call option seeks to make a profit if and when the price of the underlying asset increases to a price higher than the option strike price. In other words, the price of the option is based on how likely, or unlikely, it is that the option buyer will have a chance to profitably exercise the option prior to expiration. The seller receives the purchase price for the option, which is based on how close the option strike price is to the price of the underlying security at the time the option is purchased, and on how long a period of time remains till the option’s expiration date. The expiration date may be three months, six months, or even one year in the future. The buyer of the option can exercise the option at any time prior to a specified expiration date. The seller of the option is obligated to sell the security to the buyer if the latter decides to exercise their option to make a purchase. A call option, commonly referred to as a “call,” is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price – the strike price of the option – within a specified time frame.