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The primary purpose and function of a call option in a derivatives transaction is to give the buyer the right, but not the obligation, to buy an underlying asset at a specified price (the strike price) on or before a certain date (the expiration date). The buyer pays a premium to the seller (writer) of the call option for this right.
Here’s a breakdown of the key purposes and functions of using a call option:
For the Buyer (Holder) of the Call Option:
* Speculation on Price Increase: The most common reason to buy a call option is the expectation that the price of the underlying asset will rise above the strike price before the expiration date. If the price increases sufficiently, the buyer can exercise the option to buy the asset at the lower strike price and then sell it at the higher market price for a profit (minus the initial premium).
* Leverage: Call options allow traders to control a large amount of underlying asset with a relatively small upfront investment (the premium). This leverage can amplify potential gains if the price moves favorably.
* Hedging Short Positions: If an investor has short-sold an asset, buying a call option can limit their potential losses if the price of the asset unexpectedly rises. The call option acts as a price ceiling.
* Creating Synthetic Long Positions: Buying a call option and simultaneously selling a put option with the same strike price and expiration date can create a payoff profile similar to directly owning the underlying asset. This strategy might be used for various reasons, such as managing margin requirements.
For the Seller (Writer) of the Call Option:
* Generating Income (Premium): The seller receives the premium upfront from the buyer. This is the primary motivation for writing call options.
* Speculation on Price Stability or Decrease: A seller might write a call option if they believe the price of the underlying asset will remain below the strike price or only increase slightly. In this scenario, the option is likely to expire worthless, and the seller keeps the premium.
* Potential to Sell the Underlying Asset at a Desired Price: If the price of the underlying asset rises above the strike price and the buyer exercises their option, the seller is obligated to sell the asset at the strike price. This can be a way for the seller to lock in a selling price they find acceptable.
* Enhancing Portfolio Returns: Investors who own the underlying asset might write “covered calls” (selling call options on an asset they already own) to generate additional income from the premium. However, this strategy limits their potential profit if the asset price rises significantly above the strike price.
In summary, the call option serves as a flexible tool in derivatives transactions, primarily offering the buyer the potential to profit from price increases with limited downside risk (capped at the premium paid), while providing the seller with income and potential opportunities to sell an asset at a specific price or profit from price stability.

Video courtesy of ABN-AMRO

Video courtesy of ABN-AMRO