What are call options?

A buyer can purchase a call option to have the right to buy 100 shares for $50 each (the strike price) until the option’s expiration date. In this case, the buyer hopes the price of the underlying stock will increase to above $50.

Say the stock price increases to $55. The buyer can choose to exercise the call option for $50 and gain $5 per share – that’s a total return of $500. However, the buyer must still pay the seller a premium. If the premium was $3 per share, then the call option costs $300 for the 100 shares, meaning the buyer’s net return is $200.

This example doesn’t account for any additional commissions, fees, or tax implications, which can significantly impact net returns.

How call options work in financial markets

Call options can be compared to a wager between two investors: one investor believes the underlying asset’s price will increase while the other thinks it will decrease.

The basic features of a call option are:

• Underlying asset: The asset on which the option is based, such as a stock, bond, or commodity. This is sometimes referred to as ‘the underlying’.
• Strike price: The predetermined price at which the buyer can purchase the asset if they choose to exercise the option.
• Expiration date (Expiry): The date by which the buyer must choose whether to exercise the option or let it expire.
• Premium: The fee paid by the option buyer to the seller.

The two main players in a call options contract are the buyer and the seller:

• Call option buyers: Pay a premium for the right, but not the obligation, to purchase the underlying at the strike price before expiration. Their risk is limited to the premium paid, but their profit potential is theoretically unlimited if the asset’s price rises above the strike price.
• Call option sellers: Receive a premium in exchange for the obligation to sell the asset at the strike price if the call buyer chooses to exercise the option. Their profit is limited to the premium they receive, but their risk is theoretically unlimited if the asset’s price increases significantly above the strike price and the seller doesn’t already hold the underlying shares (also referred to as selling a ‘naked’ call).

If the underlying asset’s market price increases above the strike price, the buyer can exercise the option or sell it at a higher market value. If the asset’s price falls below the strike price, the option expires worthless and the buyer loses only the premium paid.

A call option can be said to be in the money, at the money, or out of the money. When the underlying asset is trading above the strike price, it’s considered to be ‘in the money’ (ITM). This means the option has intrinsic value. When the underlying asset is trading at the strike price, the option is ‘at the money’ (ATM). This means it has no intrinsic value but could still hold time value. When the asset’s price is below the strike price, the option is ‘out of the money’ (OTM). In this case, the option has no intrinsic value and can expire worthless.

Most call options use one of two expiration rules, known as American and European options:

• American options: Can be exercised at any time before expiration. This gives more flexibility if an option is in the money before expiration and the holder has cash-flow or inventory preferences.
• European options: Can only be exercised on the expiration date. This means the underlying asset can only be delivered at the end of the options’ life.

Despite their names, American and European options refer to exercise rules rather than geographical location. Both types are traded globally and subject to the same pricing principles.

How do businesses use call options for hedging financial risks?

Businesses can use call options contracts to manage financial risks in fluctuating markets. Below are some examples.

Commodity price risk

Companies in industries like transportation and manufacturing can use call options to hedge against fluctuating commodity prices. For example, a food manufacturer can buy a call option on agricultural products to protect against adverse price movements. If commodity prices move unfavorably, they can exercise the call option to purchase the asset at the strike price. To do this, they might partner with a company offering commodity risk management solutions.

Foreign currency risk

Companies involved in international trade can use call options to hedge against currency fluctuations. For example, if a company based in the U.S. expects to pay for goods in euros, it can buy a euro call option to cap in an exchange rate and protect against local currency depreciation.

Interest rate risk

Businesses with variable-rate loans or bonds may use call options to hedge against interest rate risk. For example, a company could purchase interest rate options to potentially offset higher borrowing costs.

Call options vs put options: Understanding the differences

There are two types of options contracts: call options and put options:

• Call options: Call options give buyers the right, but not the obligation, to buy an asset at a specified price on a future date. Investors can purchase call options if they believe the asset’s price will increase, or sell a call option if they believe the asset’s price will decrease.
• Put options: Put options give buyers the right, but not the obligation, to sell an underlying asset at a specified price on a future date. If the buyer exercises the option, sellers (or writers) are obligated to buy the asset. Investors can buy put options if they believe the asset’s price will decrease, or sell a put option if they believe it will increase.

Call options vs put options

The table below offers a side-by-side comparison between call options and put options.

	CALL OPTIONS	PUT OPTIONS
THE RIGHT GRANTED TO BUYERS	To buy the underlying asset	To sell the underlying asset
MARKET VIEW	Bullish (Buyers expect prices to increase)	Bearish (Buyers expect prices to decrease)
PROFIT POTENTIAL	Buyers can potentially profit if the asset’s price increases above the strike price	Buyers can potentially profit if the asset’s price falls below the strike price
LOSS POTENTIAL	Limited to the premium paid for the option	Limited to the premium paid for the option
SELLER OBLIGATION	Seller is obligated to sell the asset	Seller is obligated to buy the asset

What factors influence the pricing of call options?

A call option’s price is influenced by various factors, including the underlying asset’s price, time to expiration, volatility, and interest rates:

Underlying asset’s price

The price of the underlying asset is the most important factor determining a call option’s value. When the asset’s price increases above the strike price, the option’s intrinsic value increases, and vice versa.

For example, if a call option is purchased with a strike price of $50, and the underlying asset’s value rises to $55, then the option’s value will also increase as it allows the holder to buy the asset at $5 below market price.

Strike price

The strike price is the predetermined price at which the option holder can buy the underlying asset. The relationship between the strike price and the current market price of the asset plays an important role in determining the option’s value. Options with a strike price closer to the asset’s market price are typically more expensive as they have a higher likelihood of being profitable, and vice versa.

Time to expiration

Call options tend to lose value as they approach their expiration date. This is known as time decay. The more time left until expiration, the higher the option’s value as there’s a greater chance for the underlying asset’s price to move favorably.

For example, consider two call options on the same stock. They both have a strike price of $200 but one expires in two weeks and the other expires in three months. Even if the stock’s price is currently $200, the three-month option will be more valuable because it offers a longer window for potential price increases.

Volatility

Volatility represents how much the underlying asset’s price fluctuates. Options on assets with higher volatility tend to be more expensive as there’s a higher potential for returns. There are two types of volatility: implied volatility is based on the market’s expectations of future price movements, while historical volatility is based on past price movements.

For example, a stock might have implied volatility during a company’s earning report season. Because there’s uncertainty around the report’s outcome, the stock’s price has the potential to increase or decrease significantly. In this case, call options on the stock could be priced higher.

Interest rates

Interest rate changes can also influence options pricing. Generally, rising interest rates tend to increase the value of call options because the cost of carrying the underlying security becomes higher for the seller. However, the relationship between interest rates and call option prices depends on other factors, including market conditions and the asset's sensitivity to interest rate changes.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.