What is a Call?

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Definition:

A call is a broad term that can be used to describe either an option contract or a stock market auction.

🤔 Understanding a call

A call option is a contract that gives the buyer the right, but not the obligation, to purchase a stock at a predetermined price on or before a specific date. A call can also be used to describe a stock market auction. This occurs when a stock has limited trading activity and the exchange provides a window for buyers and sellers to be matched off using an auction-style system. A “call auction” is when buyers set a maximum price to buy, and sellers a minimum price to sell, a security.

Example

When the United States government needs to raise cash, one way it does this is to issue Treasury Notes. Sometimes, the government will do this using a call auction. The seller, in this case, will be the government, and the buyers will be individual and institutional investors.

Takeaway

A call is like a bid...

The term can be used in different contexts. Sometimes putting in a bid is only gives you the option to follow through and buy something; sometimes it commits you to the sale.

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What is a call option?

A call option is a contract between two parties that gives the buyer the right to purchase stock at an agreed price on or before the expiration date.

What is a call auction?

A call auction is a time when buyers and sellers set a maximum price to buy — and a minimum price to sell — a security. This matching process typically increases liquidity and decreases volatility. Usually, call auctions will occur on smaller stock exchanges or are used to issue other instruments, such as bonds.

How do a call auction and a continuous trading market differ?

Flexibility and liquidity are the two differentiating factors.

A call auction will match off buyers and sellers during a predetermined trading window. The call auction will be liquid during trading sessions; the market is then illiquid until the next session. A continuous market, on the other hand, is flexible, with transactions occurring throughout trading hours. Buyers and sellers are matched off at fluctuating market prices.

Call markets are typically used for organizing small markets. This structure is used by many governments to sell government debt instruments, such as bonds.

What are some important terms to know?

  • Matching Orders: Matching orders are buy and sell orders for a security or derivative at the same price.
  • Order driven system: Order size will determine what the price will settle at for the auction.
  • Strike price: The agreed purchase/sell price of the underlying security of the call options contract.
  • Call option premium: The agreed premium paid by the buyer to open the options contract.
  • Expiration (or expiry) date: The date at which the options contract will expire.
  • In the money (ITM): A call option is said to be in the money if the current price of the stock is higher than the strike price.
  • Out of the money (OTM): A call option is said to be out of the money if the latest stock price is below the strike price.
  • At the money (ATM): When an option’s strike price is the same as its market price, then it is said to be at the money.
  • Time value: A call option premium is made up of two components, time and intrinsic value. The amount of time determines time value until the expiration. To calculate this metric, you would subtract intrinsic from the total option premium.
  • Intrinsic value: The intrinsic value (IV) of a call option can be calculated by subtracting the strike from the stock price.
  • Time decay: The closer a call option gets to expiration, the more the premium will reduce in value. This is called time decay.
  • Exercise: If an options contract is in the money, it can be exercised by the buyer. This means the buyer will purchase the stock at the strike price and take delivery.
  • Assignment: A seller (writer) of a call option may receive an assignment notice if the option on or before expiration is in the money and the owner of the option exercises the contract. This will mean that they will need to sell their stock to the option buyer at the agreed price.

How are call option prices calculated?

Two main models are used to calculate a call option premium – Black Scholes and Binomial. The main difference between the two models is flexibility and forecasting. The Black Scholes is more like a black box that calculates a premium based on no change in the factors (i.e., stock price, time to expiry, etc.). The binomial, on the other hand, breaks time up into sections and gives a positive or negative forecast (kind of like a what-if scenario). Both models are base templates, with many brokers developing their own models for clients. To better understand how both of these calculators work, we need to identify the time to expiration, current stock/strike price, volatility, stock dividends, and interest rates.

Time to expiration

Kind of like an insurance policy, if an option has a shorter expiration date, then time value will be less, which will ultimately make the option itself cheaper.

Current stock/strike price

The Black Scholes and binomial models will take into account the current stock and strike prices when calculating the premium. For example, if the share price is higher than the strike price, then the call option will be in the money — The models will see this option as having intrinsic value.

Volatility

Stock price fluctuations can have a dramatic impact on a call option price. High stock volatility translates into a pumped-up premium.

Stock dividends

If a stock has a dividend coming up, the option premium will adjust based on the dividend amount. In the case of a call option, the premium will be cheaper. This is anticipating a fall in the stock price when it goes ex-dividend (when a stock records who is eligible to receive a dividend).

Interest rates

An investor will benefit from interest rates if they buy a call option. The reason being, instead of having to buy the stock and outlay a bigger chunk of their cash, they can buy a call option for a fraction of the cost and keep the remaining funds in the bank earning interest. This is seen as an advantage, and the call option premium is adjusted accordingly.

What are the differences between calls and puts?

Investors looking to make a bet on the price of a stock or other underlying security can either buy or sell a call or buy or sell a put.

What is the difference?

Well, a call option gives the buyer the right but not the obligation to purchase a stock at an agreed price on or before a specific date. Conversely, if you sell a call, you must sell at the strike price if the buyer exercises the option.

A put option, on the other hand, is the complete opposite and gives the buyer the right but not the obligation to sell a stock at an agreed price. Conversely, if you sell a put, you are obligated to buy shares of the underlying stock at the strike price, should the buyer decide to exercise the option.

So, going back to the investor, if they are keen on a specific stock, they could purchase a call option, which means they would have to pay the premium. If the stock doesn’t rise past their strike price, then there would be no point in exercising the option, as the shares could be purchased on the market for cheaper. They would lose the initial cost (premium).

On the flip side, if the investor thinks a stock is going to decline in value, he could buy a put option. If the share price falls, and the strike price is higher than the stock price, then the investor can exercise the option, buy the stock at the current price (assuming the investor doesn’t currently own the stock) and sell the stock at the agreed strike price. The risk, in this case, is if the stock stays at or above the strike price and the investor will lose the premium paid.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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