What is a call option?
You already know what a call option is without even realizing it. You practice the fundamentals of a call option every time you use a coupon at the grocery store.
Call Options: A Fancy Name for a Grocery Discount Coupon
Call options are financial derivatives that give the purchaser the right to buy an item at a set price for a preset amount of time. The call purchaser pays the seller a premium (fee) for this right. The purchaser has the option, but no obligation, to buy the asset. In contrast, the seller must sell the item at the set price for the duration of the option’s life if the buyer decides to follow through with the contract.
Advantage Calls
The primary use of call options is protection against upside risk in the FX market. These contracts protect you against rising currency prices. You pay for the right to have that option, but the premium is the most you’ll forfeit if you decide not to buy. Call options can be either exchange-traded or OTC (over-the-counter, privately negotiated).
CAll Option Example
Call options are much like grocery store discount coupons, especially purchased coupon books. You, the shopper, can clip a coupon that gives you the right to buy a bag of potato chips at a price lower than the retail (shelf) price.
- Retail Price: $3.99
- Price With Coupon: $0.99
In this case, the coupon allows you to buy a $3.99 bag of chips for $0.99. Based on the difference between the strike price ($0.99) and the shelf price ($3.99), we would say that the call option (coupon) has an intrinsic value of $3.00.
You, as the shopper, are under no obligation to use the coupon, so, in theory, you could sell it to another shopper in the market for chips. The coupon will expire at the end of the week, so like an option, it has an expiration date, after which it is valueless. The grocery store is like the option writer and is obligated to sell the chips for $0.99 until the expiration date.
Call options are financial derivatives that give the purchaser the right to buy an item at a set price for a preset amount of time.
Currency Call Options
Let’s look at an example. Say you need to buy euros to fulfill a business obligation. You can use call options to lock in a price for the euro (EUR). If you purchase a $0.99 strike call for four cents, you can buy euros (EUR) at that price even if the market moves up to $1.03 or even $1.10. If the market drops below $0.99, you probably won’t utilize the option and will forfeit the four-cent premium paid for the call option.
Call This a Conclusion
Call options are an effective way to hedge against upside risk. They literally give you options on your FX buying strategy. The opposite of a call option is a put option. Check out our article on put options to learn more.
Takeaways
- Call options are financial derivatives that give the purchaser the right (no obligation) to buy an item at a set price for a preset amount of time.
- The primary use of call options is to hedge (protect) against upside risk.
- Call options can be either exchange-traded or OTC (over-the-counter, privately negotiated).
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