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An option is a financial instrument whose value is derived from an underlying asset. Purchasers of call options gain the right, but not the obligation, to buy the underlying asset (such as a stock) at a predetermined strike price on or by a predetermined expiration date. All options contracts give the holders the right, but not the obligation, to buy or sell (in the case of a put) the underlying – but what exactly does that mean? Here, we take a closer look.
Key Takeaways
- Call options contracts give holders the right, but not the obligation, to buy some underlying security at a pre-determined price by a set expiration time.
- Unlike futures or forwards, this means that the call holder can decide whether or not to exercise that right and purchase the asset for that strike price. Otherwise, they can let the contract expire worthless.
- If the option is exercised, however, the option writer (seller) will be obligated to deliver the underlying to the long at that price.
Do Call Holders Have the Right to Buy the Underlying, or an Obligation?
The market price of the option is called the premium. It is the price paid for the rights provided by the call option. If at expiration, the underlying asset is below the strike price, the call buyer loses the premium paid – they are under no obligation to buy the stock for more than the market price is currently valuing the shares. If, however, it is above the strike price, the buyer can purchase the shares below market value and make a nice profit.
Thus, unlike other derivatives such as futures and forwards contracts, options contracts give the investor just that – the option – the make good on the contract.
The buyer of an option is therefore not obligated to buy the stock at the strike price. They just have a right to do so, if chosen, at which point they can exercise their right.
For example, let’s say that an investor buys one XYZ call option with a strike price of $10, expiring next week for a dollar. If the stock trades at $10.05 the day after the call option is bought, the investor has the right to buy the stock for $10 but is not forced to buy the stock.
What About the Writer of the Call Option?
On the other hand, a writer, or seller, of a call option would be obligated to sell the underlying asset at a predetermined price if that call option is exercised by the long. This is known as the call writer being assigned. The writer of a call option is paid to take on the risk that is associated with being obligated to deliver shares.
For example, an investor sells a call option with a strike price of $15, expiring next week, for a dollar, and the stock is currently trading for $13. In this scenario, the writer collects a premium of $100 because an equity option contains 100 options per contract. This indicates that the investor is bearish on the stock and thinks the price of the stock will decrease. The investor hopes that the call will expire worthless.
However, the day before the option expires, let’s say that the company publishes news that it’s going to acquire another company, and the stock price increases to $20. As a result, many holders of the call options exercise their options to buy. This means that the seller of the call option is obligated to deliver 100 shares of the company’s stock at $15 per share.
When Derivatives Are Obligations
Unlike options, futures and forwards contracts are legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. If held at contract expiration, the underlying security must be delivered if short, or delivery must be taken if long. The buyer of a futures or forward contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. Forwards are more customizable, but trade over-the-counter (OTC) between counterparties.
The Bottom Line
Call options give the holder of the contract the right to buy the underlying at a pre-specified price. At or before expiration, if the underlying asset rises above that strike price, the holder can exercise the option, obligating the seller of the option to deliver those shares at that price. If, however, the price fails to rise above the strike, the call holder can simply let his right expire without exercising it, and only lose the premium paid for the otion.