Call Options

An option that gives you the right to buy an asset at a fixed price is called a "call" option. If you buy that right, it is known as a long call; if you sell that right it is called a short call.

Call options give you the right to buy the underlying stock at a predetermined price—no matter how high the stock rallies in the future—for just a small price relative to the price of the underlying stock itself. Apart from being a flexible and risk-limited leverage instrument, call options are good hedging instruments for any stock portfolio.

Manipulated properly, call options allows you to profit from any move in the underlying stock, take advantage of new trends or swings very quickly and hedge away positional risks. Small retail investors use call options as speculative instruments to try to make a big profit from very small amounts of money and big institutional investors use them to protect their stock portfolios and to increase marginal revenue.

How do call options work?
Call options are financial contracts between a buyer and a seller for the purchase of a particular stock (or whatever other underlying asset it is based on). The seller or "writer" is giving the buyer of those call options the right to buy his stocks at a fixed price.

The buyer or "holder" of these call options can now hold on to them, hoping that the stocks will rise in price over time, before the call options contract expires, and then either sell the call options to another buyer at a higher price or exercise the right vested in the call options to buy the stock from the seller at the lower agreed price. Then the holder can turn the stock around for a profit by selling them in the open market.

Call Options: Sellers
Naturally, the seller or "writer" of call options expects the value of his stocks to stay flat or to go down. If he is correct, selling call options on those stocks actually results in additional income, offsetting the drop in his stock's market value. This hedges the risk of owning those stocks without having to sell the stocks. This is known as a covered call.

For instance, let's say you sold a call option on ABC at the fixed price of €125 when ABC is trading at €125 and receive a €20 premium. By expiration of those call options, ABC drops to €105 but your account value remains the same as the loss of €20 is hedged by the €20 premium that you received from selling (or writing) the call options.

Call Options: Buyers
Conversely, the buyer of those call options expects those same stocks to go up and is willing to pay a small price to speculate on that bet. The trading volume ratio between put options to call options on the open market is a widely used investor sentiment indicator known as the put-call ratio.

As an example, let's say you bought a call option to buy CBA at the fixed price (known as the strike price) of €180 when CBA is trading at 180 € per share for 10 €. By expiration of those call options, CBA rises to 200 €. Because the call option allows you to buy CBA at €180, it has now a value of €20 per share built into it, making a €10 profit (€20 less the €10 premium you paid to own the call options). You can now simply sell the call options for that €20 value or exercise your right to buy CBA at €180 and then sell it in the open market for its present market price of €200.

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