Call options
If you are interested in investing, you have probably heard of several financial instruments, including the "call option. A call option is an instrument investors use to diversify their portfolios and take advantage of price increases in underlying assets. We will explain exactly what buying a call option is and how it works.
What do you buy when buying a call option?
Buying a call option gives the buyer the right to buy an underlying asset, such as a stock, at a predetermined price (the strike price) during a certain period (the term) in the future. This offers some advantages and risks:
Advantages:
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Potentially high profits: If the price of the underlying asset increases, the buyer of the call option can profit from the increase without the obligation to own the asset. This can lead to significant gains relative to the initial investment.
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Limited Risk: The maximum loss to the buyer of a call option is limited to the premium paid. This means that even if the price of the underlying asset does not rise as expected, the loss is limited to the premium paid to acquire the option.
Risks:
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Time decay: Options have an expiration date. If the price of the underlying asset does not rise fast enough, the option may become worthless at expiration, resulting in the loss of the entire premium.
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Unanticipated price movements: If the price of the underlying asset does not rise as expected, the buyer of the call option may suffer a significant loss, particularly if the price falls below the strike price plus the premium paid.
Fictitious example:
Let's say that share ABC is trading at €50 per share. You expect the price of share ABC to rise in the coming months. You buy a call option with a strike price of €55 and a premium of €3 per share. If the price of share ABC rises within the term of the option to, say, €60 per share, you can exercise the option and buy share ABC for €55 and then immediately sell it for €60, resulting in a profit of €2 per share (€60 - €55 - €3). However, if the price of ABC stock does not rise above €55 before the option expires, the option may become worthless and you lose the full premium of €3 per share.
