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Call Option

A call option is a derivative security that grants to owner of the option the right to purchase a specified amount of an underlying security at a specified price (the “strike price”) at a specified time (the “exercise date”).

By owning a call option on an underlying investment, a payoff from call option will occur if the price of the underlying investment exceeds the strike price of the option when the option is in effect.

The payoff of a call option is illustrated below:


As the payoff structure illustrates, the holder of the call option receives a payoff when the price of the underlying investment exceeds the strike price; however, if the price of the underlying investment does not exceed this amount there is no payoff.

Notice that the payoff structure is single sided – that is, it has a positive payoff when the price of the underlying investment exceeds the strike price, but no loss if the prices is below the strike price.  This is because, as its name implies, the purchase of the underlying investment is optional to the holder of the option, therefore the holder of the option will only exercise the it when it is in his/her financial interest to do so.

Because of this single-sided payoff, a call option has value and must therefore be acquired at a price.  The price of a call option is dependent upon a number of factors, including:

The current price of the underlying investment – the higher the price of the underlying investment, the more valuable the call option

The strike price – the lower the strike price, the more valuable the call option.

The exercise date – the later the exercise date, the more valuable the call option (this phenomenon is often referred to as the time value of the option)

The volatility of the underlying investment – the more volatile the underlying investment, the more valuable the call option (as there is a greater probability that  price of the underlying investment will move to a point above the strike price).

The prevailing risk free interest rate – the higher the interest rate, the lower the value of the call option.

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Glossary

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