Definition of call option

A call option is a derivativeĀ that consists of the right, but not the obligation, to buy a certain amount of the underlying instrument at a given price, the strike price, on or before a certain time. Here the 'underlying instrument' means a security such as a bond or a share, a commodity, or sometimes another derivative orĀ financial product. In the case of the simplest form of option, a European option, the purchase can only be made at one point in time, the exercise time. American options can be exercised at any time up to an expiry date.

If, at the exercise time, the price of the underlying is greater than the strike price of the option, the holder realises a profit of the difference between the two prices, less the amount paid for the option. If on the other hand the strike price is greater than the price of the underlying asset, the option will expire worthless, since the holder will choose not to exercise the right to buy. So an option has an unlimited potential upside, but a limited downside - in no case can one lose more than the price paid for the option.

Call options on a company's stock are often given to executives as an incentive. If they are successful in raising the share price of the company, the executives stand to profit. If not, then their options lose their value.

European options are among the simplest derivatives to value, and the European call is used in the classic example of risk-neutral pricing, with the famous formula given by Black and Scholes. The Black-Scholes formula always gives a price for a call which is greater than its redemption value would be, if it were to expire immediately. In the absence of price changes, the value of the option will always decrease. This loss to the holder is compensated by the gains which can be made by delta-hedging the option.[1]

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