Call options are market contracts that give the option holder the right to buy the underlying security -- usually stock shares -- at a specified price. The call option's value is based on the relationship between the price at which the option can be exercised and the stock price on which the option is based.
Call Option Structure
A call option is defined by the underlying stock, the price at which it can be exercised and the expiration date. For example, say the IBM April 140 Call option is a call on IBM stock that can be exercised at a share price of $140 until the third Friday in April. The exercise price for a call option is called the strike price. If the option holder elects to exercise, he will buy shares of IBM from the option seller at $140 per share. If IBM is trading higher, the trader has an automatic profit. Each option contract is for 100 shares of the underlying stock.
Option Price Levels
A call option occurs at one of three price levels in relation to the value of the underlying stock. If the option strike price is above the current price of the stock, the option is out-of-the-money -- OTM. If the strike price is below the stock price, the stock is in-the-money -- ITM. When the stock price is at the option strike price, the option is said to be at-the-money -- ATM. Only an in-the-money call option has intrinsic value.
Option Premium Values
The quoted price for a call option is called the premium. An option buyer will pay the premium for the rights the option gives, and the seller collects the premium and must deliver the stock if the option is exercised. The call option premium consists of the time premium, which is the value received for the right to exercise the contract until it expires, and any intrinsic value. OTM and ATM option premiums consist entirely of time value. In-the-money option values are a combination of time value and intrinsic value.
Calculating Intrinsic Value
When a call option is in the money, the intrinsic value in the option price increases dollar-for-dollar with any increase in the stock price. This is the goal of a call option buyer. The intrinsic value is calculated by determining how much the option is ITM. Any remaining option premium is time value. For example, the IBM 140 call has an option price of $9.10 and IBM stock is at 144.80 per share. The stock is $4.80 above the strike price, so the $4.80 is the intrinsic value and the remaining $4.30 is time value.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.