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A call option contract gives the owner the right but not the obligation to buy a specified amount of tokens at a strike price within a specified option expiry time.
Consider a scenario, Joe wants to buy 1kg of gold. But Joe is looking out for the best time to buy. At this moment, gold is priced at $50,000. Joe heard a rumour that many small countries are going to increase their gold reserves to hedge against inflation in 6 months. But since this is highly speculative because if countries didn’t increase their reserve, the price of gold won't shoot up(can also crash). Joe has a good friend Ben who is also a jeweller. Joe wants to play it safe, he thinks of the whole situation and finally proposes a structured arrangement to Ben, which Joe believes to be a win-win for both of them.
The arrangement is as follows:
- 1.Joe will pay $1k upfront today. Consider this as non-refundable agreement fees that Joe pays.
- 2.Against this fees, Ben agrees to sell 1kg of gold to Joe after six months at $50,000.The price of sale is fixed today.
- 3.Because Joe paid an upfront fee to Ben, Joe can call off the deal at the end of 6months (if he wants to do this).
- 4.Ben cannot call off the deal. If Joe calls off the deal at the end of six months, Ben gets to keep the upfront fees.
Now there are three possible outcomes at the expiry - Small countries started increasing their gold reserves. Price of gold shoots up to $60,000. Small countries did not start increasing their gold reserves to fight against inflation. Price of gold crashes to $40,000. Nothing happens, the price of gold stays at $50,000.
Since the countries started increasing reserves as per Joe's expectation, price of gold has also increased. Joe has the right to buy gold from Ben as per the agreement at $50,000. So Joe will be making : Agreement Fees = $1,000 Buy Price = $50,000 Current Price = $60,000
Net profit for Joe = 60000 - 50000 - 1000 =$9,000
It turns out that countries increasing reserves was just a rumour and because of that the price crashes. So in this case, it doesn’t make sense to purchase gold and Joe will call off the deal. So he will incur a loss of $1,000.
For whatever reasons, price of gold stays at $50,000. Joe will walk away from the deal obviously and would not buy the gold. So in this case also, he will incur a loss of $1,000.
Call options provide the owner of the option the right (again, not an obligation) to purchase the described amount of underlying tokens at the specified strike price, by the option's maturity date. Buyers of call options believe the underlying token could go up in price over time.