Saturday, December 19, 2009


Call Option

A call option on a share or any asset is a right to buy the share at an agreed exercise price. Suppose that the current share price of company X share is 130$. You expect that price in a three month period will go up to 150$. But you do fear that the price may also fall below 130$. To reduce the chance of your risk and at the same time to have an opportunity of marking profit, instead of buying the share, you can buy a three month call option on company X share at an agreed exercise price of, say, 125$.

Ignoring the option premium, taxes, transaction costs and the time value of money, will you exercise of your option if the price of the share is 130$ in three months?

You will exercise your option since you get a share worth 130$ by paying an exercise price of 125$. You will gain 5$ that is, the pay off or the value of your call option at expiration is 5$. Your call option is in the money at maturity.

What will you do if the price of the share is 120$ when the call option on company X expires?
Obviously, you will not exercise the option. You gain nothing. Your call option is worthless, and it is out of the money at expiration. You may notice that the value of your call option can never be less than zero.

Call Premium

A call buyer exercises his right only when the outcomes are favorable to him. The seller of call option, being the owner of the asset, gives away the good outcomes in favor of the option buyer. The buyer of a call option must, therefore, pay up front a price, called call premium, to the call seller to by the option.

The call premium is a cost to the option buyer and a gain to the call seller. What is the net pay off of the buyer and the seller of a call option when the call premium (that the buyer has to pay to the seller) in involved?

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