A call option is a contract in derivatives trading, giving the buyer the right (not obliging them) to buy a security at a given price by a given date. If exercised, the seller of the option will have to part with the security at the strike price, irrespective of the market price.
How does a call option work?
An analogy of a lottery ticket works well for explaining how a call option works in real life. When we buy a lottery ticket, most often than not, we end up losing the ticket-price money spent on the lottery ticket, but we don’t have to pay any more despite being on the losing side. But if we turn out to be the winner on that ticket, we end up with windfall gains. So, the upside of a lottery ticket is unlimited (the jackpot), while the downside is limited to the ticket price, which is already taken out of our pockets.
Similarly, we may buy a call option on a security, say a stock, by paying the premium amount (the lottery ticket price) at a specific strike price (a predetermined rate of the stock). If, by the given date in the contract, the market price of the stock exceeds the strike price, we can cash in the profit (our lottery win). If the market price by the due date is the same or less than the strike price, then we lose the premium amount (ticket price) on the call option.
Since stocks can soar to any level, the difference between the strike price and the market price during the contract theoretically can be infinite.
What is the cost of a call option?
The cost of a call option is the premium paid to buy the option. An option is exercised only when it is In the money ( ITM ). The maximum loss incurred on a call option is the premium paid.
Call option vs. Put Option
A put option gives the buyer the right, but it’s not an obligation to sell the underlying asset at the specific price at the end of the period whereas the call option gives the buyer the right, but it’s not an obligation to buy the underlying asset at the specific price at the end of the period.
Types of the call option
Long call option
An option that gives the buyer the right but not the obligation to purchase a stock at a strike price in the future is known as a long call option. The benefit of a long call is that it enables you to foresee the future and buy a stock at a discount.
Short call option
In the future, the seller agrees to sell their shares at a certain strike price. For covered calls, or call options where the option seller already owns the underlying stock for their options, short call options are typically employed. If the deal does not work out for them, the call helps them limit their losses.