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# Call Options

Unlock the complexities of Call Options in corporate finance with this detailed exposition. Dive deep into the financial implications, understand the mathematical formula behind leverage, and gain a comprehensive understanding of when to buy, hold or sell these contracts. With a walkthrough of real trading examples, you can grasp the idea of Call Options in a practical light. To further fine-tune your business acumen, this piece also takes you through advanced concepts, balancing strategies and various use scenarios for a well-rounded viewpoint. Delve into the fascinating world of Call Options and strengthen your business studies proficiency.

## Understanding Call Options in Corporate Finance

Call options represent an interesting piece of the finance world, playing a significant role in corporate financing. They offer shareholders a way to hypothesis on the future price of a company's shares, alongside a safety measure to limit losses.

### Defining Call Options: The Call Option Meaning

A call option is a financial instrument giving the option holder the right, but not the obligation, to purchase a set volume of shares, often a hundred, at a predefined price, known as the strike price, within a certain time period. This significantly differentiates it from a share, where ownership confers preferential rights over the company's assets and earnings.

So, what happens in a typical call option scenario?
• The option buyer pays the premium for the right to buy the shares in the future.
• The option seller collects the premium and bears the obligation to sell the shares at the strike price should the buyer wish to exercise his option.
Have a look at these essential lingo:
 Option Holder The buyer of the option Option Writer The seller of the option Strike Price The price at which the buyer can purchase the shares during the duration of the option Premium The price paid by the buyer to the seller for the call option

### When to Choose a Call Option: Buy Call Option Conditions

Determining whether to buy a call option relies upon several considerations. Here are the criteria you may want to consider:
• If you believe that the share price will rise significantly beyond the strike price before the option expires, a call option could offer much larger returns.
• If you want to hedge existing equity investments. A call option acts as insurance against a drop in share price.
• If you want to take a speculative position in the stock but limit potential losses. The maximum loss in a call option is the amount paid as premium.
Here, formulaically, the payoff from a call option $$c$$ is calculated as: $c = max(0, S-K)$ Where: $$S$$ is the spot price of the underlying stock and $$K$$ is the strike price.

### Practical Look at Trading: Call Option Examples

Let's bring all these together with a representative scenario. Imagine you purchase a call option with a strike price of £100 for a premium of £5. Suppose the price of the share rises to £120 at expiry. You can exercise the option, buy the share for £100 and sell it for £120 on the market, gaining a profit of £15, net of the premium. However, if the share price falls to £90, you do not exercise the option and lose only the £5 premium.

It's noteworthy that the concept of call options is not limited to stock markets. It can extend to commodities, foreign exchange, and real estate, among other asset classes. This underlines their versatility as an instrument in various investment strategies.

## Diving Deeper into Call Options

Trading and investing in financial markets involves a diverse array of tools. Call options lie within the more sophisticated end of these tools. With a solid groundwork in place, let's venture deeper into the world of call options, kicking off with the mathematical calculations that underscore their valuation.

### The Mathematics Behind It: Call Option Formula

Understanding the mathematics of call options requires an exploration of two key factors - the intrinsic value and the time value. The intrinsic value is the difference between the stock's current price and the strike price. If the stock price is less than the strike price, the intrinsic value is zero, as the option would not be beneficial to exercise. So, if we denote the stock price as $$S$$ and the strike price as $$K$$, the intrinsic value $$V$$ can be described as: $V = max(S - K, 0)$ The time value, on the other hand, takes into account the remaining time until the option expires and the stock's volatility. Theoretically, the longer the time and the higher the volatility, the higher the possibility that the option can be profitable. Calculating the time value is often done using complicated models like the Black-Scholes Model. This model, developed by economists Fisher Black and Myron Scholes, made a significant breakthrough in option pricing and is widely used by option traders despite its assumptions being sometimes oversimplified. The formula for a European call option price $$C$$ under the Black-Scholes Model is given as: $C = S_0e^{-qt}N(d_1) - Ke^{-rt}N(d_2)$ Where, $$N()$$ is the cumulative distribution function of the standard normal distribution $$t$$ the time to maturity, $$S$$ the spot price of the asset at time $$t$$, $$K$$ the strike price, $$r$$ the risk-free rate, $$q$$ the rate of a continuously paying dividend, and $$d_1$$ and $$d_2$$ are defined as: $d_1 = { [ln(\frac{S_0}{K}) + (r - q +\frac{\sigma^2}{2}) t] / {\sigma \sqrt{t}} }$ $d_2 = d_1 - \sigma \sqrt{t}$ Here, $$σ$$ is the volatility of returns of the underlying asset. Computing this formula calls for a solid understanding of calculus and statistics and, in practice, is often done using finance calculators or software.

### Balancing the Choices: Difference Between Call and Put Option

As you dive deeper into options trading, it's crucial to differentiate between call options and put options. Both belong to the umbrella of derivative financial instruments, granting the buyer the right (yet, not obligating them) to buy or sell an asset. Particularly, a call option involves the possibility to buy, whilst a put option provides the right to sell. In short, the key differences are:
 Call Option Put Option Gives the buyer the right to buy an asset Gives the buyer the right to sell an asset Beneficiary when asset price increases Beneficiary when asset price decreases Maximum loss limited to the option premium Maximum loss can be substantial if the asset price increases
In essence, the selection between a call and a put option depends on your market forecast. If you anticipate the underlying security to appreciate, you would purchase a call option. Alternatively, if you predict a downward dynamic, a put option would be your preference. Both instruments serve as efficient ways to hedge your portfolio, speculate on price movements, or fetch income through option premiums.

## Expanding Knowledge on Call Options in Business Studies

As you traverse the realm of Business Studies, particularly corporate finance, the instrumental role of call options isn't challenging to discern. They serve as building blocks for advanced investment, hedging, and speculative strategies, with many financial professionals deploying them in various market conditions. Let's dive deeper and explore the intricate facets of this financial instrument.

### Advanced Aspects of Call Options

Call options showcase dimensions that go beyond the basic knowledge of premium, strike price, and expiry date. Their utility and behaviour underpin more complex aspects, three of which we'll be discussing here. Firstly, the 'moneyness' of an option is a term often encountered in option discussions. It refers to the relationship between the strike price of the option and the current price of the underlying asset. The option may be 'in the money', 'at the money', or 'out of the money' if the stock price is above, at, or below the strike price, respectively.

"In the Money" option: An option that, if exercised, will yield a positive cash flow. For a call option, it implies that the current stock price is greater than the strike price.

Secondly, the 'implied volatility' of an option is the estimated volatility of the underlying asset that the market participants expect in the future. It's a measure of the market's expectation of relative rate at which the price of an asset moves (either up or down). High implied volatility often indicates a significant price alteration. Last but not least, the concept of 'Option Greeks' emerges. Referencing different factors influencing the price of option contracts, they help us to measure the sensitivity of the price of an option to various factors, like the price of the underlying asset, volatility, time to expiry, and interest rate. Option Greeks include:
• Delta: Measures the rate of change of option price with respect to changes in the underlying asset price.
• Gamma: Measures the rate of change in the delta with respect to changes in the underlying price.
• Vega: Measures the sensitivity of the option price to changes in the volatility of the underlying asset.
• Theta: Measures the sensitivity of the option price to the passage of time, often referred to as time decay.
• Rho: Measures how much the option price is expected to change when the interest rate changes.

### Revisiting Call Option Examples with a New Perspective

To illustrate these concepts further, let's revisit the call option example once more. Suppose you buy a 3-month call option on a share currently valued at £50, the strike price of which is also £50, at a premium of £5. This implies you're anticipating the share price to rise above £55 (strike price + premium) to make a profit within the said duration. If the share price does rise to, say, £60, you could exercise the option, purchase the share at the strike price of £50, and consequently sell the share immediately at the current market price of £60, realising a tidy profit, net of the premium paid.

However, supposing the market took an unpredictable turn, and the share price didn't appreciate as anticipated but instead took a nosedive and plunged to £40 within the said period, the call option would be 'out of the money'. At this point, exercising the option will yield a loss as you would be obliged to buy the share at the strike price of £50, which is, unfortunately, higher than the market price of £40. Luckily, you do not need to exercise the option and can limit the loss to the premium you paid initially when you entered the contract.

### Exploring Use Scenarios: When to Buy Call Option

#### Evaluating Call Option: Use Cases and Scenarios

Trading call options are popular for a variety of reasons. Market participants employ them for various strategic plays - speculation, hedging, or even creating unique payoff profiles. Let’s elucidate these applications in more detail. 1. Speculation: This is the most common use, where a trader anticipates a price increase and uses a call option to generate income based on the price augmentation. 2. Hedging: Some market participants use call options to hedge their existing positions. Say, for instance, you hold a position in a stock but suspect it might fall in the near term, you could purchase a put option to hedge against this downward risk. Alternatively, if you're short on a stock and expect the price to rise, buying a call option will protect you from any significant upward move. 3. Creating unique payoff profiles: Here, call options are utilised to create a variety of payoff profiles. Consider, for example, the 'straddle' strategy, which involves buying a call and a put option on the same stock with the same strike price and expiry date. This strategy is implemented when you expect a large movement in the stock price but are unsure of the direction. This way, if the stock price moves significantly in either direction, you're bound to make a profit from one of the options, potentially covering the cost of the other. In conclusion, considering the use scenarios and the various factors in play, it’s crucial to thoughtfully and strategically analyse the market when choosing when to buy a call option.

## Call Options - Key takeaways

• Call options are a financial instrument that allow the holder to purchase a set volume of shares at a predefined price within a certain time period. This differentiates from traditional shares where ownership grants rights over company's assets and earnings.
• In a call option transaction, the buyer pays a premium for the right to buy shares in the future, while the seller collects the premium and has the obligation to sell the shares at the strike price if the buyer exercises their option.
• To decide whether to buy a call option, considerations include believing the share price will significantly rise beyond the strike price before option expiry; wanting insurance against a drop in share price; or desiring a speculative position in a stock with limited potential losses.
• The payoff from a call option can be calculated using the formula $$c = max(0, S-K)$$, where $$S$$ is the spot price of the underlying stock and $$K$$ is the strike price.
• The differences between a call option and put option depend on your market forecast. A call option allows the buyer to purchase an asset and benefits them when asset price increases, whereas a put option allows the buyer to sell an asset and benefits them when the asset price decreases.

#### Flashcards in Call Options 12

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How do call options function?
Call options give the holder the right, but not the obligation, to buy a specific amount of an underlying asset, typically shares, at a set price (strike price) within a specific time frame. They work by paying a premium for this right. If the market price rises above the strike price, the holder can exercise the option, buying the asset at the lower price. If not, the option expires worthless.
What is a call option?
A call option is a financial contract that gives an investor the right, but not the obligation, to buy a certain amount of shares, bonds, commodity, or other instruments at a specified price within a specific time period. The specified price is called the 'strike price'.
What are call options? Could you provide an example, please?
Call options are financial contracts that give the option holder the right, but not the obligation, to buy a specified amount of an underlying security at a pre-determined price within a specified time frame. For example, an investor buys a call option for a company's shares at £10 each, which they can exercise within a three-month period. If the price rises to £15, they can buy at £10 and make a profit.
What is a call option versus a put option? Please write in British English.
A call option gives the holder the right, but not the obligation, to buy an asset at a specified price within a certain period. Conversely, a put option allows the holder to sell an asset at a predetermined price within a specified timeframe.
How can one calculate the price of a call option?
The price of a call option can be calculated using the Black-Scholes model, which includes factors such as the underlying price, strike price, time until expiration, risk-free rate and volatility. Other methods include binomial models and Monte Carlo simulations.

## Test your knowledge with multiple choice flashcards

What are some of the circumstances under which you might choose to buy a call option?

What is the potential payoff from a call option?

What is the main difference between a call option and a put option?

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