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 (see foreign exchange option)
and physical such as gold or crude oil.
Example of a call option on a stock
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.