Options are categorized in two classes, calls and puts. We will illustrate what is a call option by using an example of a potential house buyer in order to explain options in more common terms. If someone understands the house example below then he/she understands how call options are fundamentally working.
Suppose that George is the owner of a house. He agrees with Mary to sell his house to her after a year at the price of $200,000. In their agreement Mary has the right but not the obligation to buy the house at a predefined price one year later and she must pay George some money in order to have this right i.e. $5,000. George takes this money and keeps them, no matter what will happen after one year. He will not return them to Mary but he is obliged to keep the agreement if asked by her. The market price of the house the day of the agreement is $190,000. So after a year what might have happened?
Case 1 : The market value of the house will be $230,000. Mary exercises her right to buy George’s house at the predefined price of $200,000. Her choice was profitable because if she would like to buy the house now without having booked a price, she would have paid $230,000 which is $30,000 more than the predefined price of the agreement. But George on the other hand didn’t make a wise choice because if he hadn’t sold this right to Mary he could sell his house at market prices after a year at $230,000 instead of $200,000 that he had agreed with Mary. So Mary bought this right because she believed that house prices will be up and George sold this right because he thought that house prices will be down after a year.
Case 2 : The market value of the house is $160,000. Mary has no interest to exercise her right to buy George’s house at $200,000 because she can buy another house at market prices much cheaper at $160,000. So her right is expiring worthless. George on the other hand is not selling his house at $200,000 to Mary because she didn’t exercise her right. The advantage for him was the $5,000 he took from Mary.
If you understood the above example you know how a call option is working. All you have to do is replace the word ”house” with the phrase ”100 stocks”. Let’s make the analogies:
1. George is the seller (writer) of the option and Mary is the buyer
2. The $5,000 that Mary paid in order to have the right is the premium
3. The predefined price of $200,000 is the strike price
4. The expiration of the option is one year from the agreement
5. The underline asset is the house
In real option markets instead of exercising the right a buyer can sell the same option in order to close the position and take profit from the higher premium in which he/she will sell it (see page ”Trading options”).
Conclusively, a call option gives its buyer the right but not the obligation to buy the underline asset in a fixed date in the future at a predefined price, whereas it gives its seller the obligation to sell the underline asset in a fixed date in the future at a predefined price if the right is exercised against him/her.
The buyer of the call wants the price of the underline asset to be higher because she has booked a buying price, whereas its writer wants the price of the underline to be lower in order not to be exercised against him and earn as much as he can from the premium.
In stock options one contract (call or put) refers to 100 stocks.