Presentation on:

CALL OPTIONS
Definition

• It is a derivative contract between two parties. The buyer of the call option earns a right
(though is not obligated ) to exercise his option to buy a particular asset from the call option
seller for a stipulated period of time
• The right is obtained by the buyer by paying a sum of money (option price) to the seller and
this money is paid when the option contract is initiated.
• The fixed price at which the option holder can buy the underlying assets is called premium
or exercise price.
• American option is when you can exercise your contract any day that the market is open
before the expiration date.
• European option is when the only time you can exercise your contract is the last trading day.

Note: Option may be written on any type of asset => most common is stock
Types of Call Options
• There are two types of call options as described below.
• Long call option
• Is a standard call option in which the buyer has the right, but not the obligation, to
buy a stock at a strike price in the future.
Advantages
• It allows you to plan ahead to purchase a stock at a cheaper price.
• Unlimited profits
• Losses are limited to premiums (the maximum losses that the buyer of a call
option will bear are limited to the premiums paid for the option).
Example: you might purchase a long call option in anticipation of a newsworthy
event, say a company’s earnings call.
Short call option

A short call option is the opposite of a long call option. In a short call option, the
seller promises to sell their shares at a fixed strike price in the future. Short call
options are mainly used for covered calls by
• the option seller, or call options in which the seller already owns the underlying
stock for their options.
• The call helps contain the losses that they might suffer if the trade does not go
their way. For example, their losses would multiply if the call were uncovered
(i.e., they did not own the underlying stock for their option) and the stock
appreciated significantly in price
Exercise styles:

1. European:
• Gives owner the right to exercise the option only on the expiration date.

2. American:
• Gives owner the right to exercise the option on or before the expiration
date.
Key elements in defining an option:

• Underlying asset and its price S

• Exercise price (strike price) K
• Expiration date (maturity date) T (today is 0)
• European or American.
Calculations

• A. Minimum Values of Options

• 1. Minimum Value of Call
• A call option is an instrument with limited liability. If the call holder sees that it is advantageous to
• exercise it, the call will be exercised. If exercising it will decrease the call holder's wealth, the
• holder will not exercise it. Thus, the option cannot have negative value, because the holder cannot
• be forced to exercise it.
• Therefore, C ³ 0
• For an American call, the statement that C ³ 0 is dominated by a much stronger
• statement : Ca ³ Max (0, S-E). The expression Max (0, S-E) means "Take the maximum value of
• the two arguments, zero or S-E"
Cont….
Long Call Option
• One can think of the buyer of the option paying a premium (price)
for the option to buy a specified quantity at a specified price any
time prior to the maturity of the option.

• Consider an example
Long Call:
• Graph 1 below shows the profit and loss of a call option with a strike
price of 40 purchased for $1.50 per share, or in Wall Street lingo, "a
40 call purchased for 1.50."
Comments:
• When buying a call, the worst case is that the share price doesn't rise to
the strike price and you lose only the cost of the call, $1.50 per share in
this example.
• The horizontal line to the left of 40, the strike price, illustrates that loss.
To the right of 40, the profit-loss line slopes up and to the right. Losses
are incurred until the long call line crosses the horizontal axis, which is
the stock price at which the strategy breaks even.
• In this example, the breakeven stock price is $41.50, which is calculated
by adding the strike price of the call to the price of the call, or 40 + 1.50.
Above 41.50, or to its right on the diagram, the long call earns a profit.
• Note that the diagram is drawn on a per-share basis and commissions
are not included.
Short call:
• Graph 2 below shows the profit and loss of selling a call with a strike
price of 40 for $1.50 per share, or in Wall Street lingo, "a 40 call sold
for 1.50.“
Comments:
• The horizontal line to the left of 40, the strike price in this example,
illustrates that the maximum profit is earned when the stock price is at
or below $40.
• To the right of 40, the profit-loss line slopes down and to the right.
Profits are earned until the short call line crosses the horizontal axis,
which is the stock price at which the strategy breaks even.
• In this example, the break-even stock price is $41.50, which is
calculated by adding the strike price of the call to the premium
received for selling the call, or 40 + 1.50.
• Above 41.50, or to its right on the diagram, the short call incurs a loss.
• Note that the diagram is drawn on a per-share basis and
commissions are not included.
• The seller of the call has the obligation to sell the underlying shares of
stock at the strike price of the call.
• Therefore, a short call has unlimited risk, because the stock price can
rise indefinitely.
• The profit potential, however, is limited to the premium received when
the call was sold.
Benefits of call diagrams

• Visualizing a strategy
• Revealing profit potential, risk, and the break-even point
• Enabling comparisons to other strategies
ITM
• In The Money (ITM) is defined as an option’s state of moneyness – the
underlying asset’s status when compared to the price at which it can be
bought or sold (strike price).
• Specifically, In The Money means that an option on an underlying asset has
gone beyond its strike price, giving it an intrinsic value of more than $0.
• A call option is ITM when its exercise price is below the current price of the
underlying asset, whereas a put option is ITM when its exercise price is
above the current market price.
• If the asset price has gone beyond the strike price, it is referred to as Out of
The Money.
ITM
• If it is equal to the strike price, it is at the money (ATM)
• Ideally, a trader always wants their option to be in the money at the
time of expiry, otherwise it will expire worthless
• In the money means that the option has an intrinsic value, and that it
can be exercised. However, just because the option is defined as in the
money, does not mean that it will return a profit
• An option costs money to buy, so it will only be considered profitable
if the amount made on the trade exceeds the initial premium paid
• If an option is an ITM then the premium can be higher
ITM
• The premium of an option can also be higher if there is a greater
chance that the option will soon be in the money, such as in periods
of higher volatility or if the options has an expiry date much further in
the future.
Example of ITM
• Lets say shares of company ABC are currently trading at $300 per
share. A call option with a strike price of $250 would be in the money
because the option holder could buy the option and sell it straight
away for $250 – the intrinsic value of this option would be $50
• Alternatively, if you had bought a put option on the shares of ABC,
with a strike price of $350, it would be in the money because the
option holder could buy the option and sell it straight away for $350.
the option would have a value of $50.
• However, if an option is already ITM at the time of purchasing, the
trade will need to move further in to the money to make a profit
OTM
• Out of The Money (OTM) is the term for when an option has not yet
reached its strike price.
• It can be a call option or put option
• A call option is OTM if the strike price (preset price) of the underlying asset
is higher than the current market price
• In a put option, on the other hand, the option is OTM if the market price
of the underlying asset is higher than the strike price
• An OTM contract possesses no intrinsic value, it has only extrinsic value
• Traders of OTM options strive to sell the options before the expiry so as to
minimize the degree of loss they would incur on the options
OTM Example
• Assume that you have a call option with a strike price of $10 and the
underlying stock is trading for $8. The option is OTM because of the
higher strike price and the more the stock’s actual price falls, the
more out of the money it becomes
• Now assume you have a put option at $10 and the underlying stock is
trading at $12 a share. Again you are out of the money because if you
exercised the option you would sell for less than what the stock is
trading for on the open market. And the higher the price goes, the
further you go out of the money.
Difference between ITM and OTM
• An ITM (In The Money) option is one with a strike price that has already been surpassed
by the current stock price whilst an OTM option is one that has a strike price that the
underlying security has yet to reach, meaning the option has no intrinsic value
• In options trading, the difference between ITM and OTM is a matter of the strike price’s
position relative to the market value of the underlying stock, called its moneyless
• ITM options have intrinsic value and are priced higher than OTM options in the same
chain, they can be immediately exercised
• OTM are nearly always less costly than ITM options, which makes them more desirable
to traders with smaller amounts of capital
• OTM options are commonly traded for strategies such as covered calls or protective puts