A call option is a financial contract between
two parties, the buyer and the seller of the option, that allows
the buyer, then owner, of the option the right but not the obligation
to buy an agreed quantity of a particular commodity
or financial
instrument from the seller of the option at a certain time (or
times depending on the exact specification of the contract). for
a certain price, known as the strike.
"Selling" in this context is not supplying something that the
seller owns, but it means granting the buyer this right, against
a fee.
The most widely-known call option is that when the option is to
buy stock in a particular
company. This is a stock
option. However options are traded on many other quantities
both financial, such as interest
rates (called an interest
rate cap) or foreign
exchange rates and physical such as gold or crude oil.
I might enter a contract to have the option to buy a share in
Microsoft Corp. on June 1 2005 for $50. If the share price is actually
$60 on that day then I would exercise my option (i.e. buy the share
from the counter-party). I could then sell it in the open
market for $60, i.e. the option would be worth $10; my profit
would be $10 . If however the share price is only $40 then I would
not exercise the option (if I really wanted to own such a share,
I could buy it in the open market for $40, why waste $50 on it).
My option would be be worth nothing. Thus in any future state of
the world, I am certain not to lose money by owning the option.
This implies that the option itself must have some positive value
(the price of the option). This value varies with the share
price and time. The science of determining this value is the central
tenet of financial
mathematics. The most common method is to use the Black-Scholes
formula. Whatever the method used, the buyer and seller must agree
this value initially and the buyer pays the seller this value as
a fee.
Like in the case of share trading, buyers and sellers of options
do not usually interact directly with each other; the options
exchange is intermediary and quotes the market value of
the option. The seller has to supply a guarantee to the options
exchange that he can fulfill his obligation if the buyer chooses
to execute his option.
