org/wiki/Call_option
Call option
From Wikipedia, the free encyclopedia.
Call options can be purchased on many financial instruments other than stock in a corporation - options can be purchased
on interest rates, for example (see interest rate cap) - as well as on physical assets such as gold or crude oil.
1 of 3 9/1/2005 6:51 PM
Call option - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Call_option
I buy a call on Microsoft Corporation stock with a strike price of $50 (the future exchange price)
and an exercise date of June 1, 2006. I pay a premium of $5 for this call option. The current
price is $40.
Assume that the share price (the spot price) rises, and is $60 on the strike date. Then I would
exercise my option (i.e., buy the share from the counter-party). I could then sell it in the open
market for $60. My profit would be $10 minus the fee I paid for the option, $5, for a net profit
of $5. I have thus doubled my money (beginning with $5, ending with $10 in my pocket).
If however the share price never rises to $50 (that is, it stays below the strike price) up through
the exercise date, then I would not exercise the option. (If I really wanted to own such a share, I
could buy it in the open market for less than $50, so why exercise the option?) The option would
expire as worthless. I would have lost my entire $5.
Thus, in any future state of the world, my loss is limited to the fee (premium) I initially paid to
purchase the stock, while my potential gain is quite large (consider if the share price rose to
$100).
From the viewpoint of the seller, if the seller thinks the stock is a good one, he/she is $5 better
(in this case) by selling the call option, should the stock in fact rise. However, the strike price (in
this case, $50) limits the seller's profit. In this case, the seller does realize the profit up to the
strike price (that is, the $10 rise in price, from $40 to $50, belongs entirely to the seller of the
call option), but the increase in the stock price thereafter goes entirely to the buyer of the call
option.
From the above, it is clear that a call option has positive monetary value when the underlying instrument has a spot price
(S) above the strike price (K). Since the option will not be exercised unless it is "in-the-money", the payoff for a call
option is
where
Prior to exercise, the option value, and therefore price, varies with the underlying price and with time. The call price must
reflect the "likelihood" or chance of the option "finishing in-the-money". The price should thus be higher with more time
to expiry, and with a more volatile underlying instrument. The science of determining this value is the central tenet of
financial mathematics. The most common method is to use the Black-Scholes formula. Whatever the formula used, the
buyer and seller must agree on the initial value (the premium), otherwise the exchange (buy/sell) of the option will not
take place.
Related
Moneyness
Option time value
Put option
Put-call parity
See also
Derivatives markets
Derivative security
Financial economics
Futures
2 of 3 9/1/2005 6:51 PM
Call option - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Call_option
Financial instruments,Finance
Options
Stock option
Warrants
Foreign exchange option
Interest rate options
Bond options
Options on futures
Swaption
Interest rate cap
Interest rate floor
Exotic interest rate option
Credit default option
binary option
real option
Categories: Derivatives
3 of 3 9/1/2005 6:51 PM