Call Options

Call options are essential for financial markets, enabling investors to speculate and mitigate their risks. The call option is among the most strategic and highly used kinds of options. In this blog, we look at what a call option is, how it works, the types of call options, their evolution, and give some practical examples. We would be looking more into markets excluding India. 

What is a call option? 

A call option is a security derivative that entitles the owner to buy an underwriter at a pre-set price for a given period. The underlier may be a stock, bond, commodity, index, or currency. The most important appeal of a call option is the potential to profit if the price of the underlying rises, with most of the downside risk limited to the premium actually paid for the option. 

An investor who feels that the price of a stock will appreciate in the future can buy a call option on a stock. When the stock rises, he can exercise the option to purchase the stock at the lower strike price or sell the option at a profit. 

Understanding Call Options 

The key elements underpinning the call option are the strike price, premium, and expiration date. For a call option, the holder has a right to buy specified assets at the strike price up to the expiration. The call option’s value is associated with its situation, which is in-the-money, out-of-the-money, or at-the-money. Among the key determinants affecting the value of these securities are the cost of the asset, time to expiration, volatility, and level of interest rates. For example, call options are useful in bullish markets since they provide leverage at lower costs but could also lose the premium if the market becomes adverse. 

Types of Call Options 

Call options also have different types; they may be distinguished based on the asset on which they are principal and on the market on which they are traded. Among the most common types are: 

1. Equity Call Options: These are options written on individual stocks. For example, a call option in Tesla Inc. shares presents an opportunity for the holder to buy shares of Tesla at an exercise price on or before the exercise period expires. These types of equity call options are actively traded on most stock exchanges, like the New York Stock Exchange (NYSE) and the NASDAQ. 

1. Index Call Options: These are the options based on stock indices, such as the S&P 500 or the NASDAQ 100. Index call options are one of the favourite choices for investors seeking to take positions in the market rather than on individual stocks.  

1. Commodity Call Options: Commodity call options are related to the delivery of physical commodities, such as gold, oil, or agricultural products. Companies in those industries typically use these call options to hedge against price fluctuations of raw materials. 

1. Currency Call Options: These options give the holder the right to purchase a given currency at a pre-determined rate. Multinational organizations and forex traders commonly use these options to hedge adverse currency movements. 

1. Interest rate call options: These are options with interest rates as the underlying, which help the holder be entitled to interest in different interest scenarios. Fixed-income investors also use them to handle interest rate risks. 

Each call option model addresses specific market participant needs in different ways. For instance, equity call options are attractive to retail investors and traders intending to take advantage of potential stock price appreciation; index call options are relatively more attractive to institutional investors who want to protect their overall market risk. 

Evolution of Call Options 

The call option was born in the 20th century. The establishment of the CBOE (Chicago Board Options Exchange) in 1973 was a turning point in options trading, as it became the first exchange to list standardized and regulated options contracts, including the call option. 

Before standardized options, options trading was conventionally done over the counter, and contracts were tailored to fit the needs of both parties. The absence of this standardization greatly reduced options trading to the average investor and severely restricted the market. 

Now, such standardized call options of CBOE have ushered several benefits, such as increased liquidity and transparency, which, in turn, substantially decreased counterparty risk. The introduction also allowed the development of models for the pricing of options, like the Black-Scholes model, which gave a theoretical foundation for the valuation of options. 

This market has increased substantially in the early times and positioned calls among the most widely traded financial derivatives. The introduction of electronic trading platforms and the greater proliferation of ETFs further expanded access and demand for call options, placing them as one of the most important financial instruments for retail and institutional investors alike. 

Examples of Call Options 

The use of call options can be best explained by referring to a few examples from the US market: 

1. Equity call option: Suppose an investor buys call options on the shares of Amazon.com Inc., with the exercise price on these options equal to US$3,000, with an expiration date in two months. For example, when Amazon rises to US$3,200, investors can use the option to buy shares at US$3,000, earning a profit of US$200 per share. Alternatively, the investor could sell the option for a market price premium containing the greater intrinsic value.
2. Index Call Option: A trader who expects a bull future market could buy a call option on, for instance, the S&P 500 index. If the index appreciates considerably, he will gain from the increased value of the option. The investor is thereby able to take a position in the overall market with less capital than it would have been required to purchase the underlying instruments.
3. Currency Call Option: Assume that a multinational company anticipates the US dollar will firm up in the future against the euro. To hedge the risk of a possible fluctuation in this currency, the company buys a call option on the US dollar. If the dollar appreciates, the option to purchase dollars at a favourable price could help the company decrease the effects of the movement of the currency rates on its operations.

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