What is call and option ?

A call option is a financial contract between two parties, the buyer and the seller of this type of option. Often it is simply labeled a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.

The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price (see below for examples).

Call options are most profitable for the buyer when the underlying instrument is moving up, making the price of the underlying instrument closer to the strike price. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money".

The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset. Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.

Call options can be purchased on many financial instruments other than stock in a corporation. Options can be purchased on futures on interest rates, for example (see interest rate cap), and on commodities like gold or crud oil. A tradable call option should not be confused with either Incentive stock options or with a warrant. An incentive stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular person (typically executives) to purchase treasury stock. When an incentive stock option is exercised, new shares are issued. Incentive stock options are not traded on the open market. In contrast, when a call option is exercised, the underlying asset is transferred from one owner to another.

Call and Put Options on Stocks

 

At the heart of all the spreads and strategies discussed about options is the call and put. A call gives its owner the option to buy a stock at a specific price, known as the strike price, over a given period of time. A put provides the owner the option to sell a stock at a specific price (also called the strike price), over a given period of time. Let's look at how options are typically represented for a particular stock:

 

What Is an Option Contract?

 

Options are traded in units called contracts. Each contract entitles the option buyer/owner to 50 shares of the underlying stock upon expiration. Thus, if you purchase seven call option contracts, you are acquiring the right to purchase 350 shares. 

 

For every buyer of an option contract, there is a seller (also referred to as the writer of the option). In exchange for the cash received upon creating the option, the option writer gives up the right to buy or sell the underlying stock to someone else for the duration of the option. For instance, if the owner of a call option exercises his or her right to buy the stock at a particular price, the option writer must deliver the stock at that price.

 

Understanding Option Pricing

 

Two key phrases from our definitions for a call and put are "option to buy" and "option to sell." The owner of a call or put is not obligated to take any action. Thus, a call or put never has a value less than $0 before it expires.

 

Consider the following example:

 

You own a call that gives you the right to buy a stock for $50. However, at expiration, the stock is priced at Rs 45. Why would you exercise your right to purchase the stock for Rs 50 when you can buy it for less in the stock market? You wouldn't. So, your call is worth Rs 0 anytime the stock finishes below your strike price, which is Rs 50 in this example.

 

When talking about option prices, people often refer to intrinsic value and premium to intrinsic value. (This intrinsic value has nothing to do with the intrinsic value we refer to when talking about the discounted cash flow of a company.) An option's intrinsic value is the difference between its strike price and the underlying stock price, when it favors the owner of the option. People often refer to intrinsic value as the amount that the option is "in the money." Let's look at three examples, assuming we are in 2006:

 

60c when the stock is trading at $75

In this case, you own a call option that allows you to purchase the stock for Rs 60 when it is trading for Rs 75. We would say this call option has an intrinsic value of Rs 15 because it gives you the right to purchase the stock for Rs 15 less than you could purchase it for in the stock market.

 

80p when the stock is trading at Rs 50

In this case, you own a put option that allows you to sell the stock for $80 when it is trading for Rs50. We would say this put option has an intrinsic value of Rs30 because it gives you the right to sell the stock for Rs30 more than you could sell it for in the stock market.

 

50c when the stock is trading for Rs40

In this case, you own a call option that allows you to buy the stock for Rs50 when it is trading for Rs40. This option has no intrinsic value. It is considered "out of the money."

 

Let's take a closer look at the third example above. Although it has no intrinsic value, we discover that the option is trading for about Rs2 in the marketplace. Why is that? Although the option isn't in the money now, there is still some time left (before expiration) for the stock to move such that it could place the option in the money. This is referred to as time value or option value.

 

In the case of the second example, the option may be trading for Rs32 even though the intrinsic value is only Rs30. In this case the option is trading at a Rs2 premium to its intrinsic value. This premium is also known as the time value.

 

Drivers of Option Value

 

There are several key factors that influence the value of an option. First, the level of volatility in the underlying stock plays a key role. The higher the stock's volatility, the greater the value of the option If the underlying stock is more volatile, it means the option has a greater chance of trading in the money before the option expires.

 

Second, the amount of time left until the option expires influences the option's value. The more time left until expiration, the greater the value of the option. Again, the longer until expiration, the more time for an option to trade or finish in the money.

Finally, the direction the underlying stock trades will affect the value of the option. If a stock appreciates, it will positively affect call options and negatively impact put options. If a stock falls, it will have the opposite effect.