Legal Definitions - call option

A call option is a financial contract that grants its owner the right, but not the obligation, to purchase a specific asset or service from the seller at a pre-determined price (known as the "strike price") on or before a particular date (the "expiration date"). In exchange for this right, the buyer pays a premium to the seller.

If the asset's market price rises above the strike price, the buyer can exercise the option, buying the asset at the lower, agreed-upon price and potentially profiting from the difference. If the market price does not rise sufficiently, or falls, the buyer can choose not to exercise the option, and their loss is limited to the premium paid. The seller, in turn, is obligated to sell the asset if the buyer chooses to exercise the option, and profits from the premium if the option is not exercised.

• Real Estate Development: Imagine a property developer, "Urban Visions," identifies a promising plot of land for a new commercial complex. They need several months to conduct feasibility studies, secure necessary permits, and finalize financing. To ensure they can acquire the land at today's price, Urban Visions pays the current landowner, Mr. Henderson, a fee (the premium) for a nine-month call option. This option gives Urban Visions the right to purchase the land for $3 million (the strike price) anytime within the next nine months. If, during this period, property values in the area surge and similar plots are selling for $4 million, Urban Visions can exercise their call option, buying Mr. Henderson's land for $3 million, thereby saving $1 million (minus the premium paid for the option). If their plans fall through or land values decline, Urban Visions can simply let the option expire, losing only the premium, without being obligated to buy the land.
• Manufacturing Raw Materials: Consider "AutoParts Inc.," a company that manufactures car components using a specialized metal alloy. They anticipate that global supply chain issues might cause the price of this alloy to increase significantly in the next six months. To hedge against this potential price hike, AutoParts Inc. enters into a call option contract with a metal supplier. They pay a premium for the right to purchase 100 tons of the specialized alloy at $10,000 per ton (the strike price) six months from now. If, after six months, the market price of the alloy has indeed risen to $13,000 per ton, AutoParts Inc. can exercise their call option. They purchase the 100 tons from the supplier at the agreed $10,000 per ton, saving $3,000 per ton compared to the current market price, which helps them maintain stable production costs. If, however, supply chain issues resolve and the alloy's price drops to $9,000 per ton, AutoParts Inc. can choose not to exercise the option and instead buy the alloy on the open market at the lower price, losing only the premium paid for the option.