What are Call Options and How Do They Work?

In the world of finance, call options are a financial instrument that offer interesting opportunities to investors. These contracts give the right, but not the obligation, to buy an underlying asset at a predetermined price by a specific date. Call options have a significant influence on trading strategies and risk management, making their understanding essential for anyone operating in the financial markets.

In our guide, we will explore call options in depth, starting with their definition and main characteristics. Here is how these options work, the most common trading strategies and the factors that influence their price.

Definition and characteristics of call options

A call option is a derivative financial instrument that gives the buyer the right, but not the obligation, to buy an underlying asset at a predetermined price by a specific date. This contract offers the investor the opportunity to benefit from a potential increase in the price of the asset, while limiting the risk of loss to the premium paid for the option.

The underlying asset of a call option can be a wide range of financial assets, including stocks, bonds, commodities or currencies. The strike price, also known as the exercise price, is the fixed price at which the buyer can buy the underlying asset. The expiration date is the date by which the option must be exercised.

Call options can be American-style, exercisable at any time until expiration, or European, exercisable only on the expiration date.

How do call options work?

Call options operate according to a well-defined mechanism, offering specific opportunities and obligations for buyers and sellers.

Buyer’s Rights

• The buyer of a call option gets the right, but not the obligation, to buy the underlying asset at a predetermined price (strike price) by the expiration date. This right comes at a cost, known as the premium, which represents the maximum potential loss for the buyer. If the price of the underlying asset rises above the strike price, the buyer can exercise the option to make a profit.

Seller’s Obligations

• The seller of the call option, on the other hand, has the obligation to sell the underlying asset at the strike price if the buyer chooses to exercise the option. In exchange for this obligation, the seller receives the premium. His hope is that the price of the underlying asset will remain below the strike price, allowing him to keep the premium without having to sell the asset.

Profit and Loss Scenarios

• For the buyer of a call, the potential profit is theoretically unlimited, while the maximum loss is limited to the premium paid. The break-even point occurs when the price of the underlying asset exceeds the strike price by an amount equal to the premium. For the seller, however, the maximum profit is limited to the premium received, while potential losses are unlimited if the price of the underlying asset increases significantly.

Option Call Trading Strategies

Option calls offer several trading strategies for investors.

• One of the most common is buying calls for speculation. This strategy is used when the price of the underlying asset is expected to increase. The investor buys a call, paying a premium, with the expectation of profiting from the appreciation of the stock. The main advantage is the possibility of controlling a large amount of shares with a limited initial investment, taking advantage of the leverage effect.
• Another popular strategy is selling covered calls for income. In this case, the investor sells call options on stocks that they already own. This technique allows for an immediate premium, potentially improving portfolio returns. However, it limits potential gains if the stock price rises above the strike price of the option sold.
• More experienced investors can use spreads and combinations with other options to create customized risk-reward profiles. For example, a bull call spread involves buying a call at a certain strike price and selling another call with a higher strike price. This strategy reduces the initial cost and risk, but also limits the potential gains.

What Factors Affect the Price of Call Options?

The value of call options is influenced by several key factors that determine their price in the market. Understanding these elements is essential for investors who want to use call options in their trading strategies.

First, the price of the underlying asset has a significant influence on the value of the call option. When the price of the underlying asset increases, the intrinsic value of the call option tends to increase. This is because the option becomes more profitable for the buyer, who can buy the asset at a lower price than the market price.

Implied volatility is a measure of the market’s expectations regarding future fluctuations in the price of the underlying asset. The higher the expected volatility, the higher the premium of the call option. This is because higher volatility increases the probability that the option will end up in-the-money at expiration, making the option more valuable to the buyer.

The time remaining until expiration of the call option is another factor that impacts its time value. In general, the further away the expiration, the higher the value of the option. This is because there is more time for the underlying asset to move in the desired direction. However, the time value progressively decreases as the expiration approaches, a phenomenon known as time decay.

Tax and regulatory aspects of call options

The tax treatment of capital gains from call options in Italy is a crucial aspect for investors. Capital gains realized from the sale or exercise of call options are subject to taxation as other financial income. The rate applied is 26%, regardless of the amount of the gain. It is important to note that capital gains are taxed according to the cash principle, that is, in the year in which they are actually realized.

The options market in Italy is regulated by the Consob (National Commission for Companies and the Stock Exchange) and the Banca d’Italia. These authorities supervise the correct functioning of the market and the protection of investors. Call options traded on regulated markets are subject to specific rules of transparency and public disclosure. Financial intermediaries that offer options trading services must be authorized and comply with strict capital and organizational requirements.

And it is important to know that to operate with call options, investors must meet certain requirements. It is necessary to open a account with an authorized intermediary and sign a contract that specifies the risks associated with options trading. Many brokers require a minimum capital and adequate knowledge of derivative financial instruments.

Examples of call options: how the purchase works

Let’s take a practical example: suppose that our business consists of purchasing wheat in order to process it and obtain flour to resell. However, unforeseen events (drought, fires, etc.) could cause a limited harvest so as to create the conditions for a strong increase in prices.

To avoid paying too high a price for wheat in the coming months, we could make a deal with the farmers using a call option: we buy from the farmers the right to buy a certain quantity of wheat (e.g., 100 quintals) on a certain date (e.g., December 2025) at a very low price (e.g., €9 per quintal).

We are simply buying a call: the right to buy wheat (underlying asset) on a predetermined date (expiration date) and at a certain price (strike) by paying a given amount (premium, e.g. €0.5 per quintal). Let’s now see what can happen once the expiration date is reached (we said December 2025).

1. The price of wheat increases to €12/q. due to a disappointing harvest. Our option is convenient so we exercise it, buying the underlying at €9;
2. The price of wheat falls to €8/q because it was a good harvest. We do not exercise the right and simply write the cost of the option in the balance sheet. After all, the goal was to protect ourselves (hedging) from any price increases above €9 (function of an insurance).

Original article published on Money.it Italy. Original title: Cosa sono le opzioni call e come funzionano