What is a call option?
A call option is a financial contract that gives the holder or (buyer) the right to purchase a stock, bond, commodity or other security within a specified time period at a predetermined price. The holder is not obligated to buy the stock, but he does not recover the fee paid to the writer (or seller) of the option.
In an option’s contract, the holder is given the option to buy shares of a security at a specific price, known as the strike price, until a predetermined date, also called the expiration date. The holder pays a premium (or fee) to the seller to buy the shares. The premium is paid on a per-share basis.
Investors also can sell stock options for a profit. Sellers sell the options and hope that the stock’s price does not rise, so the option expires. If this happens, the seller has made a profit off of the premium and still holds the stock.
Call options are said to be covered if the seller owns the underlying security. Call options are referred to as naked or uncovered if the seller does not own the underlying security he or she is selling the options to buy.
Call option example
Ann believes ABC’s stock price is about increase. The stocks are currently selling for $25 per share. Ann enters a call option contract with a seller to purchase 200 shares at $27 in one month. The premium charged for the option is $2 per share, costing Ann $400. ABC’s stock price does increase to $32 per share, and Ann decides to purchase the stocks from the seller for $27 per share. Ann has made a profit of $3 per share for a $600 total. The seller has made $4 per share or $800.
If the stock’s price had instead declined or stayed the same, Ann wouldn’t be obligated to purchase the stock, but she would have lost $400 for the premium she paid to the seller.
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