What is a Call?
A call can mean two things. It can refer to an option contract giving the owner the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time. It can also refer to a call auction, a time when buyers set a maximum acceptable price to buy, and sellers set the minimum satisfactory price to sell a security on an exchange. Matching buyers and sellers in this process increases liquidity and decreases volatility. The auction is sometimes referred to as a call market.
- A call can refer to a call auction or a call option.
- A call auction is a trading method used in illiquid markets to determine security prices. A call option is a right, but not obligation, for a buyer to purchase an underlying instrument at a given strike price within a given timeframe.
Call Option Basics
Basics of a Call
A call auction is also known as a call market. The call auction is a type of trading method on a securities exchange in which prices are determined by trading during a specified time and period. A call option is a derivative product which is traded on a formal exchange or in the over-the-counter marketplace. The term call is also used by lenders when they wish to demand the full repayment of a secured loan.
Below is an example of a long call.
Below is an example of a short call.
For call options, the underlying instrument could be a stock, bond, foreign currency, commodity, or any other traded instrument. The call owner has the right, but not the obligation, to buy the underlying securities instrument at a given strike price within a given period. The seller of an option is sometimes termed as the writer. A seller must fulfill the contract, delivering the underlying asset if the option is exercised.
When the strike price on the call is less than the market price on the exercise date, the holder of the option can use their call option to buy the instrument at the lower strike price. If the market price is less than the strike price, the call expires unused and worthless. A call option can also be sold before the maturity date if it has intrinsic value based on the market’s movements.
The put option is the opposite of a call option. The put owner holds the right, but not the obligation, to sell an underlying instrument at the given strike price and period. Derivatives traders often combine calls and put to increase, decrease, or otherwise manage, the amount of risk that they take.
In a call auction, the exchange sets a specific timeframe in which to trade a stock. Auctions are most common on smaller exchanges with the offering of a limited number of stocks. All securities can be called for trade simultaneously, or they could trade sequentially. Buyers of a stock will stipulate their maximum acceptable price and sellers will designate their minimum acceptable price. All interested traders must be present at the same time. At the termination of the auction call period, the security is illiquid until its next call. Governments will sometimes employ call auctions when they sell treasury notes, bills, and bonds.
It is important to remember that orders in a call auction are priced orders, meaning that participants specify the price they are willing to pay beforehand. The participants in an auction cannot limit the extent of their losses or gains because their orders are satisfied at the price arrived at during the auction.
Example of a Call Option
Suppose a trader buys a call option with a premium of $2 for Apple’s shares at a strike price of $100. The option is set to expire a month later. The call option gives her the right, but not the obligation, to purchase the Cupertino company’s shares, which are trading at $120 when the option was written, for $100 a month later. The option will expire worthless if Apple’s shares are changing hands for less than $100 a month later. But a price point above $100 will give the option buyer a chance to buy shares of the company for a price cheaper than the market price.
Example of a Call Auction
Suppose a stock ABC’s price is to be determined using a call auction. There are three buyers for the stock – X, Y and Z. X has placed an order to buy 10,000 ABC shares for $10 while Y and Z have placed orders for 5,000 shares and 2,500 shares at $8 and $12 respectively. Since X has the maximum number of orders, she will win the bid and the stock will be sold for $10 at the exchange. Y and Z will also pay the same price as X. A similar process can be used to determine the selling price of a stock.
Examples of strategies using calls and puts include the seagull option.
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