Call Option


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.

Example

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 spend 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 certain strike price (a predetermined price 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.


Source: Tavaga Research