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Call option definition
What is a call option?
A call option is a contract that gives the buyer the right but not the obligation to buy a specific asset at a specific price, on a specific date of expiry. The value of a call option appreciates if the asset's market price increases.
The seller, also known as the writer, has the obligation to sell the underlying asset – at the agreed upon price, called the strike price – if the option is executed by the buyer, also known as the holder. The seller is paid a premium for accepting the risks associated with the obligation to sell.
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Example of a call option
Let’s say that you thought the share price of company ABC was going to increase from its current market price of £20, so you decide to buy a call option with a strike price of £25. For stock options, each contract is worth the equivalent of 100 shares, but the price is usually quoted for just one share.
When dealing options there is always a premium to be paid. If the premium of this option is £1 per share, your total premium would be £100.
If the price of ABC shares did rise, to a market price of £30, you could buy that stock from the seller at the agreed-upon strike price of £25 and resell it into the market for an immediate £5 profit per share. This would earn you £500, but you would still need to subtract your premium – meaning your overall profit would be £400.
If the market moved against you, you could let the option expire and you’d only lose the initial £100 premium.
Pros and cons of call options
Pros of call options
Call options are leveraged allowing you to get full market exposure while only having to deposit a relatively small amount of capital - the premium when buying, and margin when selling.
When you buy a call option, your losses are capped at the total cost of the premium. However, when you sell a call option, your risk is potentially unlimited because you have the obligation to sell the underlying to the holder at the strike - and there's no telling how far past this the market could rise.
Cons of call options
Options are susceptible to time decay, which means that the value of an out-of-the-money options contract decreases as it gets nearer to its expiry date.
Call options are complicated and could be costly for beginner traders who aren’t aware of the risks. This makes it important for traders to have a risk management strategy in place before they start trading.
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