What is a call option? or an equity call option?

by Girl Banker

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An equity call option gives the buyer the right to buy a given number of shares in a given company at a given price on a given date (European-style option) or at any point with a given period of time (American-style option). Only the option buyer can exercise the option.

To buy a call option is called going long a call and selling a call option is going short a call. 

Example
Whilst Apple shares are trading at about $80 a share in late 2006 you decide to buy a call option that gives you the right to buy 1,000 shares in Apple Inc. at $200 anytime between 1 Jan 2010 and 31 Dec 2010.

Buying out-of-the-money call options is much cheaper than actually paying the money to buy the shares outright.

The call options are referred to as being out-of-the-money because the strike price, $200, is higher than the current share price of $80. If you buy this contract, you would be expressing the view that you believe in the company so much that you expect the share price to more than double over a four year period. This view would be the basis for buying the right to buy the shares at $200 in four years time, though the current value is only $80.

If at any point in 2010 Apple shares exceeded the option strike price of $200, you could exercise your right to buy the shares at $200 and immediately sell them to lock in a profit. Let’s say each option cost you $1, this means you would pay a premium of $1,000 for this option contract.

In Dec 2010, the Apple share price went over $320.

• You decide to exercise the option when the market price is at $320.
  
  
• You would pay $200,000 to exercise the equity call option contract: $200 strike price multiplied by 1,000 shares.
  
  
• You would then immediately sell all those shares at the market price of $320, locking in an immediate profit of $119,000:
  $320,000 current market value of 1,000 shares
  minus $200,000 option contract value received on sale (when you exercise the contract)
  minus $1,000 premium paid to enter into option contract 
  = $119,000 

In summary, buying equity call options implies the buyer believes the share price will go up and they want to profit if this does happen. The higher the share price is above the strike price, the higher the profit as seen below.

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