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Call Options

A call option is a financial derivative that gives the holder the right (but not the obligation) to buy the underlying stock at a pre-specified price (the strike price) at any time up to the day when the option expires (the expiration date). In general, the purpose of a call option is to acquire the right to buy a stock at a price lower than its current price. Investors and speculators who are bullish on the stock but don’t want to put up the entire amount up front can buy a call option for the right to purchase the stock at some later date. If, during the time the option is alive, the stock moves in your favor (up), you can exercise it and buy the stock at the pre-specified strike price. If you sell it immediately, you will profit by (S – K), less commissions.

The payoff diagram for a call option looks something like this:

In the example payoff above, the call pays nothing up to the strike price at 15, after which the option is in the money and will increase in value as the underlying stock continues to advance. Note that the diagram is only valid for the payoff at expiration. Prior to expiration, the option is worth more due to time value.

The long call option is considered to be limited risk, because you can only lose the full amount of what you put in. The naked short call option has a payoff that is the mirror image of the long, and therefore has theoretically unlimited risk. In other words, it is quite stupid to do this unless you are very, very sure that the stock price will drop.

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