What Is a Call?
A call, in finance, will usually mean one of two things.
- A call option is a derivatives contract giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time.
- A call auction occurs over a set time when buyers set a maximum acceptable price to buy, and sellers set the minimum satisfactory price to sell a security on an exchange. Matching buyers and sellers in this process increases liquidity and decreases volatility. The auction is sometimes referred to as a call market.
- A call can refer to either a call auction or a call option.
- A call option grants the right, but not the obligation, for a buyer to purchase an underlying instrument at a given strike price within a given timeframe.
- Call options are commonly used for speculating on up-moves, hedging, or writing covered calls.
- The call auction is a type of trading where prices are determined by trading during a specified time and period.
- A call auction is a trading method used in illiquid markets to determine security prices.
Call Option Basics
For call options, the underlying instrument could be a stock, bond, foreign currency, commodity, or any other traded instrument. The call owner has the right, but not the obligation, to buy the underlying securities instrument at a given strike price within a given period. The seller of an option is sometimes termed as the writer. A seller must fulfill the contract, delivering the underlying asset if the option is exercised.
When the strike price on the call is less than the market price on the exercise date, the holder of the option can use their call option to buy the instrument at the lower strike price. If the market price is less than the strike price, the call expires unused and worthless. A call option can also be sold before the maturity date if it has intrinsic value based on the market's movements.
The put option is effectively the opposite of a call option. The put owner holds the right, but not the obligation, to sell an underlying instrument at the given strike price and period. Derivatives traders often combine calls and put to increase, decrease, or otherwise manage, the amount of risk that they take.
Example of a Call Option
Suppose a trader buys a call option with a premium of $2 for Apple's shares at a strike price of $100. The option is set to expire a month later. The call option gives her the right, but not the obligation, to purchase the Cupertino company's shares, which are trading at $120 when the option was written, for $100 a month later. The option will expire worthless if Apple's shares are changing hands for less than $100 a month later. But a price point above $100 will give the option buyer a chance to buy shares of the company for a price cheaper than the market price.
Call Option FAQs
How Do Call Options Work?
Call options are a type of derivative contract that gives the holder the right, but not the obligation, to purchase a specified number of shares at a predetermined price, known as the “strike price” of the option. If the market price of the stock rises above the option’s strike price, the option holder can exercise their option, buying at the strike price and selling at the higher market price in order to lock in a profit. On the other hand, options only last for a limited period of time. If the market price does not rise above the strike price during that period, the options expire worthless.
What Does It Mean to Buy a Call Option?
Investors will consider buying call options if they are optimistic—or “bullish”—about the prospects of its underlying shares. For these investors, call options might provide a more attractive way to speculate on the prospects of a company because of the leverage that they provide. For an investor who is confident that a company’s shares will rise, buying shares indirectly through call options can be an attractive way to increase their purchasing power.
What Are Put Options?
Puts are the counterparts to calls, giving the holder the right to sell (and not buy) the underlying security at a specific price at or before expiration.
How Do I Sell a Call Option?
Options are frequently traded on exchanges. If you own an option you can sell it to close out the position. Or, you can sell (known as 'writing') a call to take a short position in the market. If you already own the underlying security, you can write a covered call to enhance returns.
What Happens If My Call Expires in-the-Money?
Expiring in-the-money (ITM) simply means that at its expiration its strike price is lower than the market price. This means that the holder of the option has the right to buy shares lower than where they are trading, for an immediate profit. The process of converting the contract into those shares at that price is called exercising. Note that a call that expires with a strike higher than the market price will be out-of-the-money (OTM) and expire worthless, since who would want to purchase shares for higher than you can get in the open market?
In a call auction, the exchange sets a specific timeframe in which to trade a stock. Auctions are most common on smaller exchanges with the offering of a limited number of stocks. All securities can be called for trade simultaneously, or they could trade sequentially. Buyers of a stock will stipulate their maximum acceptable price and sellers will designate their minimum acceptable price. All interested traders must be present at the same time. At the termination of the auction call period, the security is illiquid until its next call. Governments will sometimes employ call auctions when they sell treasury notes, bills, and bonds.
It is important to remember that orders in a call auction are priced orders, meaning that participants specify the price they are willing to pay beforehand. The participants in an auction cannot limit the extent of their losses or gains because their orders are satisfied at the price arrived at during the auction.
Call auctions are usually more liquid than continuous trading markets, while continuous trading markets give participants more flexibility.
Example of a Call Auction
Suppose a stock ABC's price is to be determined using a call auction. There are three buyers for the stock—X, Y, and Z. X has placed an order to buy 10,000 ABC shares for $10 while Y and Z have placed orders for 5,000 shares and 2,500 shares at $8 and $12 respectively. Since X has the maximum number of orders, she will win the bid and the stock will be sold for $10 at the exchange. Y and Z will also pay the same price as X. A similar process can be used to determine the selling price of a stock.