Uncovering options: What is a call option?

Julie Brownlee, Fsp Invest, 21 Aug. 2014

Tags: call option, call options, what is a call option, options, options trading, risks with options trading

If you’ve looked into the different trading instruments available, you’ll most likely have come across options.

Options trading is very popular in the States. It’s easily the most popular trading instrument retail traders use.

So what is an option? And what is a call option?

Let’s take a closer look…

What is an option?

An option gives the holder the right, but not the obligation, to buy or sell something at an agreed price on or before an agreed date.

You’ll find options available to trade on a number of shares. In South Africa, an option is based on a single stock future, which is based on the underlying share.

What is a call option?

If you want to have the right to buy something, you need to buy a call option. You would buy call options if you thought the underlying share was going to rise in value.

To do this, you’d pay the seller of the option you want, a premium. The seller of an option is known as a writer.

Let’s have a quick look at an example…

Shares in Company ABC are trading at R100 each. For a R10 premium, a call option might give you the right to buy the share in two months’ time at R105.

For you to make a profit from the trade, you’d want to see the share price rise to R115 (R105 plus R10).

If the share price does rise, the value of the option will also rise. That’s because the right to buy at R105 is more attractive as the share price rises.

This means you can make a nice profit for a much smaller outlay than if you bought the shares outright.

The risks with call options

If the share price falls, you can also lose your entire initial stake. Then the option would expire worthless. This means you would lose the premium you paid.

But options trading is slightly less risky than other forms for trading, like single stock futures. You can only lose the premium. With other trading instruments, your losses aren’t limited. Of course you can use stop losses to keep your losses in check.

So there you have it, what a call option is.

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