Posted on October 15, 2010 by Rich Browne

The first objective of a call option is to protect against rising prices of the underlying instrument, it acts as insurance. On the day of exercise, the option has intrinsic value in the event that the underlying is above the exercise price. In practice, however, the underlying security upon exercise of the option is not necessarily delivered.

Whether a cash settlement takes place or the underlying is delivered, all the relevant events are set in the contract. In principle, it is a contract that allows its holder to purchase the instrument in question, then called the underlying at a predetermined price (exercise price, also called strike) at a specific date called the date of maturity of the call.

The purchaser of a call option anticipates appreciation of the price as regards the underlying instrument at some stage in the future. While the seller may anticipating a decline, or is keen on abandoning some of the profit as a result of price increase in favor of the premium (paid off instantly).

The buyer can gain more profit with the call option in the event that the underlying instrument rises, thus drawing the price of the underlying instrument nearer to the strike price. And the risk is confined to the premium, the buyer’s profit has the capacity to be significantly high. The option drifts into a state of being ‘in the money’ whenever the price of the underlying instrument exceeds the strike price.